umarsaeed

ETFs: Explained and Exposed

In Advice, Criticism, Financial on July 14, 2011 at 1:13 PM

During the “flash crash” of 2010, the Dow dropped 1,000 points in a matter of hours because of a computer glitch. During this crunch, ETFs were impossible to sell unless you were willing to take a devastatingly low price. Why?

Greece, Ireland, Spain, Portugal and the United States all under intense pressure to avoid defaulting on their bonds. Because these bonds are so widely held, even a downgrade can force institutions to sell them off en mass. Such a sell off can easily cause liquidity issues in stock markets.

When everyone sells assets in exchange for cash and you’re one of them, you quickly find out whether your holdings are desirable. During the “flash crash” in May 2010, the Dow Jones Industrial Average fell by almost 1,000 points. According to this report from the Economist, authorities cancelled trades at unusually low prices trying to correct the glitch. Between 60-70% of those cancelled trades were in Electronically Traded Funds (ETFs), far above their actual weighting in the market.

In the same article, it was noted that as of May 2011, ETFs controlled almost $1.5 trillion of assets (not far short of the $2 trillion in hedge funds). More importantly, ETFs have attracted the average investor. They are marketed as low cost mutual funds. Trends show ETF product offerings continuing to grow in Canada. All the major banks are working on their own offerings. American companies are also moving into the Canadian market to gather our capital. Indeed, ETFs are “like” mutual funds, but ETFs have already evolved to be much more complicated than that. Most importantly, it’s not apparent where your money is invested, depending on the ETF.

Plain Vanilla ETFs

It started out as a simple and clever idea. Mutual funds take your money and select stocks to invest in, and then charge you a fee for trying to make money with your money. Empirical evidence has shown that mutual funds perform, on average, as good as a market index, which is simply a collection of stocks that represents the market as a whole. So why pay someone to manage your money when a collection of stocks that resembles the stock market does just as well?

For example, I could create something called the TSE Fab Five ETF. I would take your money and use it to purchase the five most valuable companies listed on the Toronto Stock Exchange. If a company’s value dropped outside of the top five, I would sell that company and purchase the new number five . Because it’s based on a formula, it can be automated. This ETF charges much lower fees than mutual funds, because a computer will execute these trades according to an algorithm. No financial experts necessary.

The other benefit of the ETF was supposed to be liquidity. Because ETFs are traded on major stock exchanges, you can sell it whenever you want to. Mutual funds are not traded freely, and when you want your money you don’t receive it from someone who wants the mutual fund, you actually receive it from the mutual fund company that you initially invested with. That normally takes a day.

However, the fact that ETFs are freely traded like stocks has invited speculators to trade them too. This yields some interesting results. In continuing with my TSE Fab Five example, the value of my Fab Five ETF should be close to the value of the five underlying stocks put together.

This hasn’t been the case. During the “flash crash,” it should be noted that it was hard to sell shares in ETFs as compared with owning the actual stocks. Besides, hedge funds and investment banks might be shorting my index as a part of some hedging strategy, also skewing the price of the ETF from being what it should be: the sum of its parts. The fact that ETFs can be used for investing, hedging, and speculating has increased their volatility. In other words, the ups and downs of the ETF itself can be sharp, so the burden of buying and selling at the right time goes to you.

Foreign Equities ETFs

I don’t have a problem foreign ETFs, but their mechanical workings are not intuitive. For example, if I wanted to invest in blue chip Indian stocks, I might invest in an Indian ETF. Rather than my money eventually going to the Indian stock market, it actually goes to New York through something called American Depository Receipts (ADR).

An example: Tata motors of India want foreign investors. So they take shares of Tata currently being traded in Indian stock exchanges, and trade them for ADRs that are traded on the New York Stock Exchange. Now, those ADRs represent the shares of Tata motors. New York has been providing foreign companies capital in this way for almost a century. The Indian ETF I would purchase here in Canada would use those ADRs on the NY exchange to create a basket of Indian securities. By doing it this way, I am not exposed to underdeveloped stock exchanges around the world along with various currency risks that they may present.

The risk is that because the NYSE is a middleman in this transaction, I’m exposed to the American financial system. Like plain vanilla ETFs, over the course of the long haul (ten plus years), holding on to something like this will pay off. But always know that ETFs take a back seat when it comes to getting your money back in times of crisis or a liquidity crunch. Nobody wants them. They’re too far removed from the underlying investment and diminish in value because of it.

Commodities ETFs

The role of the speculator has been demonstratively clear over the past year. With oil, food, gold, silver, etc. prices shooting through the roof, commodities ETFs have been marketed to us as a simple way to gain from rising commodity prices. Funny thing about these ETFs, many of their returns for the year are considerably lower than the price increase of the underlying commodity.

A great example is oil. With political turmoil in the Middle East, disrupting the production of oil, along with Japan’s natural disaster, the supply of crude oil was short of the demand. The NYMEX sweet crude oil price shot up almost 10% for the first five months of 2011 (according to NYMEX price history). Yet, the ETF that was designed to mimic the NYMEX (ticker: USO) barely earned 2% in the same year. Why the disparity?

For starters, with commodities it’s very impractical to actually purchase barrels of oil or whatever commodity you want to invest in. So the ETF takes your money and purchases a derivative related to that commodity to try and achieve the same effect. In the case of oil, the money is thrown into a well-developed futures market.***

The problem with commodity ETFs trading futures is that it is glaringly obvious to investment banks and hedge funds what trades they want. Investors want to profit from surging oil prices, which means they throw money into USO and other oil ETFs. The ETFs, in turn, take that money and enter into long futures contracts that will be profitable, provided the oil price keeps spiking unexpectedly, or keeps surprising the markets.

Hedge funds, investment banks and commodity traders feast off the predictable approach ETFs employ. They know which futures your ETF needs, and beat your ETF to the punch, taking away your profits. They are in a position to take the other side of the bet too, and can set the futures price too high. There have even been reports of American investment banks renting inventory space to store oil, in case the ETF demand for purchasing futures contracts dropped. It didn’t drop, and ETFs mechanically entered into unprofitable futures contracts. So oil went up, but the ETF failed to profit.

The same principle goes toward the plain vanilla ETFs discussed earlier. If a stock is on the verge of making my Fab Five index, you would expect institutional speculators to gobble it up in large quantities. Eventually, I will need to purchase the stock to stay true to the Fab Five ideology that I promised my shareholders. I have to buy it, and someone else knows this. Not good.

Synthetic ETFs

As far as I know, synthetic ETFs are not available in Canada. Unlike the ETFs discussed so far, these synthetic ones don’t even bother to invest your money in something that resembles the underlying stock or commodity being marketed. In fact, they are Total Return Swaps.

If I were to create a synthetic Fab Five ETF, I would take your invested money and create a swap arrangement with an investment bank. In exchange for your money, the bank would promise to pay the returns of the Fab Five index. While there are capital requirements in place (the bank must set aside some assets to pay these promises), the problem is that those assets set aside as collateral have nothing to do with what your desired investment is. The bank does not have to buy the Fab Five stocks.

In the end, there is an inherent investment in the health of the bank and that it can pay your ETF what it promised. The fact that these ETFs are growing popular in America shows a major failure of all the banking and regulatory reform. If the European and American bond prices spiral downward, we should expect a liquidity crunch in the global banking system. Not only would ETF prices drop sharply because they are undesirable assets during a liquidity crisis, but banks might fail too, leaving Synthetic ETF investors to wonder what they had invested in.

Advice

If your financial advisor, or someone at the bank recommends ETFs as an investment, have them explain to you exactly where your money goes. Make them draw a flow chart. With every investment, your money ultimately purchases an asset. Find out what that asset is and how it is purchased. This is also a fantastic litmus test to see if your financial adviser is actually qualified to handle your money.

For those that manage their own money, I like ETFs that use private formulas to create their basket of holdings. I also don’t mind if they hold ADRs if it gets me exposure in foreign places that I couldn’t invest in otherwise. The popularity of commodity ETFs has made them expensive to purchase, and their mechanical workings have made them easy prey for institutional speculators, so I would  stay away from them – but that depends on your appetite for risk. Probably the most important lesson to be learned from these early years of ETF popularity is that if you need the money soon, you’re exposed to an uncontrollable variable – the aggregate market supply and demand of your ETF, which has nothing to do with the value of the underlying stocks.

____________________

***A future is a derivative. It’s a contract that states I will purchase some commodity (barrel of oil) at a set price (market’s expectation of what a barrel of oil will cost at the future date) at a future date (when I need the oil). The price of crude oil on December 31st, 2010 was $91.38. Let’s say on New Year’s Eve I entered into an oil futures contract that allowed me to purchase one barrel of oil for $95 on June 3rd, 2011. As it turns out, on June 3rd the price of a barrel was $100.22. Because I have a piece of paper that allows me to purchase a barrel for $95, that piece of paper is actually worth $5.22 on June 3rd. The future contract itself is worth money.

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