Why the risk funds may be better signals than trades

We’re not huge fans of “risk on” / “risk off” explanations of global market movements around here. Not only is it simplistic to reduce all the factors that play into the rise and fall of asset classes to a simple binary proposition, but it looks like even its limited viability is evaporating fast.

Exhibit one: the ETFs created entirely to reflect binary moves towards or away from safe havens, the ETRACS Risk On (ONN, quote) and Risk Off (OFF, quote) funds that UBS launched late last year.

These funds are not widely traded, with maybe 7,000 shares of either moving in a typical day. ONN is slightly better capitalized at a total NAV close to $21 million, while OFF is significantly smaller, but more popular with traders looking for a bear market fund of last resort.

Because the two funds are so narrowly traded, it probably doesn’t make much sense for traders to simply choose one or the other extreme position and let the bets ride.

Instead, ONN and OFF function as bellwethers for global market sentiment. Obviously, as ONN rises, traders are feeling brave enough to load up on risk. As OFF rises, the nervous money is running for safe havens.

The positions in the two funds are direct mirror images of each other, so the odds are remote that they’ll move in the same direction. However, where the funds used to move in ironclad correlation with individual asset classes, the markets are now testing those relationships — and generating some surprises.

On the ONN side, just about everything we track here at Emerging Money — the emerging currencies, global stocks, commodities, gold — moved in more or less perfect step with one another until mid-March, when the situation in Europe improved and the U.S. economy looked strong.

That shift in tone lifted those stocks and the euro (FXE, quote), but left commodities (DBC, quote) and emerging markets (EEM, quote) moving in step with ONN.

If ONN truly reflects risk, then what we have been seeing is not so much a new appetite for risk but a sense that the developed world is de-risking again as the euro crisis and U.S. recession fears recede into the background.

Given the constituency for “risk on” chatter, it’s no surprise that ONN’s chart also reflects the rise and fall of speculative assets. Oil (USO, quote) and gold (GLD, quote) have tracked ONN closely, even though the underlying commodity futures should logically keep moving in line with the corporate fundamentals of U.S. and European stocks, which naturally consume more energy as they expand their business.

On the “risk off” side, OFF has done a less impressive job modeling the moves of traditional safe haven asset classes. Treasury funds like UST (quote) have often exaggerated this fund’s moves, and since about a week ago other core haven assets like the yen (FXJ, quote) and Swiss franc (FXF, quote) have decoupled from OFF entirely.

Are we seeing a return to a multipolar market where multiple asset classes chart their own destiny on a day-to-day basis? From these charts, it seems the answer is yes. That, in turn, means that the unique promise of these funds to act as an either/or proposition seems doomed.

If all the “risk” asset classes trade together, then all a trader theoretically needed to do was buy into EEM or some other massive “risk” fund and let the markets decide. But if they’re starting to diverge again, you’re probably better served to trade the parts on their own.

Performance tells the story of which impulse has been dominant in the markets. Since the funds went live on November 30, OFF is down 4% and ONN is up 6%. Clearly traders have spent the year nibbling at risk assets like emerging market stocks, currencies and commodities, and not exactly running for the exits.

However, the gap between the funds is narrowing again, indicating that optimism for ONN is fading and pessimism is pushing more people toward OFF. We may be approaching another inflection point.