UBS's New Cloud ETN Doesn't Really Offer A Pure Play On The Sector

This article is now exclusive for PRO subscribers.

There's a new cloud computing fund in town, an exchange traded product from UBS that will have the ticker symbol LSKY.

It will compete directly with SKYY, a fund that started trading in July 2010 and has since lost about 20% of its value.

Exchange traded funds and exchange traded notes are sold to investors as a good way to track an industry. The problem lies in whether the fund is tracking the industry accurately.

The problem is especially acute in new industries, like the cloud, where leadership is uncertain and hype is pronounced. In cases like this, I prefer buying the leading players and avoiding the funds. You'll get a better bang for your buck that way.

Take LSKY. Currently about 4.68% of the fund's assets are in (NASDAQ:AMZN). Makes sense, since its EC2 cloud is the largest commercial cloud out there, and its PE is similar to other cloud-based entities like VMWare (NYSE:VMW) and Red Hat (NYSE:RHT). But most of Amazon's money comes from e-commerce.

Now take the second-leading holding. Blackboard Inc. (NASDAQ:BBBB). This is not a cloud company at all. It's a software as a service (SaaS) company in the education space. They call themselves “a provider of enterprise software applications and related services to the education industry.” They trade based on the market fluctuations in education, not cloud. For the last two quarters they have not been profitable.

UBS says it's using leverage to create more price action on the fund, but I don't think I want the BBBB action. UBS has almost as much of its LSKY money in Blackboard as in Amazon, and both holdings dwarf that of their stake in Apple (NASDAQ:AAPL). (Not that Apple is really a cloud outfit either – they're just a better investment than Blackboard.)

Of the top 10 holdings, in fact, four aren't cloud at all. In addition to BBBB, these include Oracle (NYSE:ORCL), a database vendor, Cisco Systems Inc. (NASDAQ:CSCO), a networking vendor, and Apple. Oracle and Cisco are, in fact, two of the companies that are primary cloud targets.

At the heart of the cloud is the idea that you reduce your costs by getting rid of expensive enterprise vendors, with their lock-in, and going instead with a single infrastructure, open source and standards that turn all vendors into commodity providers. You might like Cisco, but it's not a cloud vendor.

So at least 16% of the fund's holdings aren't in the cloud. They don't yet break out the other 30 investments, but if this is any indication of the strategy, I'd rather have a pure play. Much rather.

When you buy an ETN, you're betting on the management of the fund to echo the performance of the sector. Personally, I think a good ETN in this area would have its biggest holdings in real cloud companies, like Rackspace (NYSE:RAX), Red Hat, VMWare and in Google (NASDAQ:GOOG). (LSKY does have large positions in VMW and GOOG.)

And I'd be light on GOOG too. I wouldn't want much in this fund that isn't starting with a current PE north of 30.

If I'm going to play the cloud, I'd like the leverage of being really in the cloud. That means companies selling actual cloud stacks or general purpose cloud services. It doesn't mean SaaS companies, and it certainly doesn't mean money-losers.

But what do I know? I got my head in the clouds.

Disclosure: I am long GOOG.