The Hidden Risks of ETFs

In just a few short years, exchange-traded funds have become the hottest item on the stock-market menu, with U.S. ETFs alone now holding more than $600 billion of investors’ money.

While that’s dwarfed by the $9.3 trillion managed by non-ETF mutual funds, exchange-traded funds have an allure that conventional funds seem to lack: In 2008, when the global financial crisis caused markets to nose-dive, investors still poured $176 billion into ETFs. Although the pace of investments have slowed this year, investors have still stashed $35 billion in new cash into ETFs – even as they yanked $49 billion out of conventional mutual funds, according to a recent report by Strategic Insight.

This popularity is understandable: ETFs trade like stocks, but can be used to target torrid markets such as China, or white-hot investing trends such as gold or commodities.

But ETFs have a dark side, too – involving risks that most investors probably weren’t aware of, but that government regulators are now investigating. Investors need to understand those risks, and make their future ETF-related investment choices accordingly.
The government inquiry could bring a lot of those risks to light.

CFTC Hearing: In the Spotlight, On the Hot Seat

In a hearing on Wednesday – in what amounted to a rare regulatory assault on speculators – the U.S. Commodity and Futures Trading Commission (CFTC) heard testimony from people who produce, manufacture and hedge commodities and commodities-based products. Among the targets of interest were several of the gigantic exchange-traded funds that allow investors to place bets on certain specific commodities, as well as on diversified, commodity-based indexes.

The CFTC oversees regulated futures exchanges and has been examining how those exchanges could dampen energy-price volatility, possibly by limiting the number of “futures contracts” that hedge funds, investment banks and other speculators can control. Wednesday’s hearing was the third the CFTC has held.

Commission Chairman Gary Gensler reiterated his view that the CFTC should "seriously consider" speculative position limits for energy futures trading. The agency plans to publish any rule proposals this fall.

But executives with the ETFs that invest heavily in energy commodities on Wednesday told the CFTC that that the funds were not the cause of the wild price gyrations experienced by crude oil and natural gas.

John Hyland, chief investment officer (CIO) for U.S. Commodity Funds LLC – an industry player with $3.9 billion in assets under management as of March 31 – was one of the big ETF players on the hot seat. Hyland is the CIO of both the United States Oil Fund LP (NYSE: USO) and the United States Natural Gas Fund LP (NYSE: UNG) – two ETFs that are among the largest such products in the world.

The executive said that ETFs provide market liquidity by helping buyers and sellers find each other.

“We believe that the significant increases in energy prices last summer were wholly unrelated to the activities of our commodity-tracking funds using the commodity futures market to hedge the exposure to investors that results from their obligation to track the price movement of a commodity," Hyland said. “In fact, rather than acting as a source of risk, the funds provide investors with a transparent, highly regulated, unleveraged vehicle through which to hedge their pre-existing price risk in commodities."

The U.S. Oil Fund peaked last February at just over $4 billion, and is now down to $2.4 billion. Oil’s sister fund, U.S. Natural Gas, stands at an even-larger $4.5 billion, and is pending approval from the U.S. Securities and Exchange Commission (SEC) to issue even more shares. The size of the funds points to increasing investor interest in energy-based ETF products – and possibly to the potential for increased volatility in the underlying price of both oil and natural gas.

As of last July, investors who bet on commodities – including the energy complex of instruments – had more than $300 billion directly invested just in index funds designed to track the value of commodity futures, reports the Paris-based International Energy Agency (IEA).
The question at the forefront of the CFTC hearings is whether all this interest is properly placed.

Last year, after oil zoomed upward to establish an all-time-record high in excess of $145 a barrel, a CFTC report attributed the near-vertical price escalation and accompanying volatility on supply-and-demand factors.

Walter Lukken, former U.S. President George W. Bush’s acting-CFTC chairman at that time, later testified to the House Committee on Agriculture that the CFTC “did not find direct evidence that speculation was driving up prices.”

According to The Wall Street Journal, CFTC Commissioner Bart Chilton dissented from the 2008 report, calling the data “deeply flawed,” as well as limited and unreliable.

“We didn’t have all the information we should have and we gave it to Congress anyway, and we spun it,” Chilton is reported to have said at the time.

Enforcement Turf War

U.S. President Barack Obama’s appointment of Gensler as new CFTC chairman began a turnaround at the agency. Addressing speculation in commodities from the CFTC’s perspective intersects with – and perhaps even conflicts with – the power and authority of the SEC squarely in the front yard of ETFs.

ETFs are governed by the SEC and generally come under the rules and regulations of the Investment Company Act of 1940. But, when it comes to commodity-based ETFs, the underlying instrument, or index being tracked, is considered the front yard of the CFTC.

When it comes to commodity-based ETFs, the CFTC and SEC have to work together, something that hasn’t happened in the past.

The problem with so many investors, or speculators, betting on oil and gas – be it directly, or through indexed benchmarks – is that in order for ETF funds to actually track a commodity or index, the funds’ operators must generally trade in the underlying futures markets to take positions that ETF investors are trying to emulate.

The problem with this entire exercise is that if there are finite amounts of a commodity being pursued by increasing amounts of speculative capital, what will happen to prices, and how will the ebb-and-flow of capital influence price volatility?

Investors vs. the Speculators

At the peak of 2008’s commodity grab-fest, the total notional market value of all U.S. commodity futures and options contracts was less than $1 trillion. According to Barron’s, “that’s less than the market value of just five oil companies, and far less than the trillions in speculative funds that could be invested in commodities.”

As interest in commodity investing and hedging and portfolio diversification increases, the lines between speculation and investing may become indistinguishable.

Placing position limits on institutions and traders transacting in the futures markets could go a long way to dampen excessive speculation, no matter how that’s ultimately defined.

But, it won’t solve the problem; in fact, it could increase volatility and boost systemic risk. The reason: ETFs can use complex financial instruments known as derivatives. These can include swaps (swap dealers are exempt from position limits), as well as highly customized exotic instruments – fashioned as private contracts – to mimic any commodity, commodity index, stock or stock index the ETF operator wants to track.

Investors Beware

For investors, the very proliferation of ETFs that makes them attractive to investors – because the explosion of choices makes it easy to play the trend of the day – also makes them highly risky. Not that there is anything wrong with ETFs. They are great – conceptually speaking. But so were mortgage-backed securities before they were sliced and diced into products with nuclear cores that melted down.

It’s one thing for an ETF to track a benchmark or any duly created “index” by actually holding the underlying stocks that make up that index (which isn’t always practical and often isn’t economical). But it’s quite another for the underlying instruments to consist of  derivative contracts.

The problem is with the derivatives. Someone actually takes the other side of these contracts and is expected to make good on them if they are called upon to make delivery on some underlying credit, real asset or cash. But, as we saw with Lehman Brothers Holdings Inc. (OTC: LEHMQ) and American International Group Inc. (NYSE: AIG), even the biggest counterparties with whom contracts are written may not be able to fulfill their paper commitments.

Then there’s the multiplier effect – a “daisy chain” of risk. When a “synthetic” obligation is created, it exposes the contracted party to risk. To mitigate that “paper” – but very real – risk, another derivative is often created to offset the initial contract risk, and then sold to another counterparty.

Wall Street loves ETF products because they have created another separate profit center for the insiders to rape and pillage. The cover is often explained as a healthy arbitrage that keeps the EFT universe of instruments trading near their net asset values. While that’s true, it’s a built in goldmine for the Street, which when it becomes tilted away from them will cost the markets and our faith in them to once again crumble.

It works like this: So-called “authorized participants,” or AP (read that to mean chosen relationships or Wall Street insiders), actually buy or create the underlying tracking portfolios, usually in 50,000-share packets known as “creation units.” The ETF sponsor engages in an “in-kind” swap, accepting the units from the AP in return for an equivalent amount of ETF shares. Finally, the AP, through their relationship outlets, sells the ETF shares to buyers, who bid for them on the exchanges.

The opposite can also happen. In a so-called “redemption,” only APs can buy back ETF shares and swap them for the creation units that are the actual underlying instruments.

When the shares of an ETF trade, for any number of reasons, at a discount or premium to their net asset value, or NAV, the APs rush in to “arbitrage” the difference. Buying or selling shares, and swapping them out on the other side to the ETF sponsors, theoretically drives the ETF price closer to NAV. There are billions of dollars to be made – chiefly by insiders, or those connected to insiders – in this exercise, which is why it’s become a business in and of itself. The more ETFs there are, the more locked-in arbitrage opportunities there are for the insiders. It’s brilliant. The problem, not just because I didn’t think of it, is that is skews trading-volume figures, creating a false sense of liquidity – and with that a false sense of safety.

Credit Suisse Group AG (NYSE ADR: CS) now estimates that ETFs account for a quarter of U.S. equity volume.

But now that you understand how this works, here are three obvious – and somewhat scary – questions to ask:

  • How much then of the volume we presume to be available on a daily basis in our markets actually consists of ETF-related arbitrage-transaction volume, meaning it isn’t actually providing greater liquidity?
  • And does that mean that our financial markets are actually in much worse shape than we realize?
  • And, lastly, are the ETFs that retail investors employ to be safer than individual stocks in reality much-riskier instruments?

The questions will be answered – and the reality revealed – when a significant hitch occurs in the stock market’s trading mechanisms, an eventuality you can count upon seeing.

Back to the Future?

The New York Stock Exchange (NYSE: NYX) is already building a 400,000-square-foot fast-trade-hub on the site of an old rock quarry in New Jersey, where it will house the high-frequency-trading computers that are required in order to trade in microseconds (millionths of a second). And the reason – you guessed it – is to give traders a leg up on the arbitrage-type opportunities that the quickly expanding ETF universe continues to create. Regulators, specifically at the SEC, are worried that the glitches that such a rapid-fire-trading marketplace can create will generate systemic risk way beyond anything they can conceive of, let alone calculate.

On a more mundane level, leveraged ETFs and inverse ETFs have finally been fingered as the day-trading vehicles they really are – meaning that they’re inappropriate for the masses who bought them to “hedge” or increase their bets on a controlled basis. They don’t work as they were promoted.

Already, Edward D. Jones & Co. LP, Morgan Stanley Smith Barney (NYSE: MS), and The Charles Schwab Corp. (Nasdaq: SCHW) are steering customers away from these products. The Financial Industry Regulatory Authority (FINRA) has issued warnings and guidance for broker-dealers on determining suitability of these products for clients. And UBS AG (NYSE: UBS) has suspended the sale of leveraged, inverse and inverse-leveraged ETFs.

What may begin as an assault on speculators may very well end up being an assault on speculative instruments. If the end result of that exercise is that ETFs end up being scrutinized from every angle in order to assess their efficacy and the risk they pose to both investors and to the overall markets, we’ll all end up being the better for it.

Right now it’s probably a big revelation that ETFs – a growing favorite of the retail investor – is actually the latest wolf in sheep’s clothing bred by Wall Street.

Also surprising is that speculation isn’t the real problem here.

The problem is that – even after one of the worst financial crises we’ve seen since the Great Depression – Wall Street is still infecting the economy with suspect – and even toxic – instruments that make insiders rich while exposing the rest of the world to their infectious greed.

Let’s hope that the CFTC gets the ball rolling with the currently scheduled hearing, that the SEC follows up with an investigation of its own, and that Congress then steps in to keep this from happening all over again.

[Editor’s Note: As detailed look at popular exchange-traded funds underscores, the global financial crisis made the investing game much more tricky than ever before. has changed the rules of the investing game forever.

But don’t let that reality scare you way. The flip side is that the global economic recovery will create an estimated $300 trillion worth of global-investing-profit opportunities. To profit, you just need to know where to look.’

And for that, you need a guide. In a free Money Morning Webinar, Investment Director Keith Fitz-Gerald will detail the “$300 trillion global recovery” that will create some of the most profitable investment opportunities that we’ll see in our lifetime. Fitz-Gerald will outline this opportunity, as well as some specific companies global investors might want to consider. To find out more about this free Webinar, please click here.]

Also, two related stories that appear elsewhere in today’s issue of Money Morning further detail the controversies involving exchange-traded funds (ETFs). In one story, investors detail the profit potential they believe that ETFs continue to offer individual investors. To access that story directly, please click here. The second story details the results of a hearing from earlier this week, as well as the regulatory challenges that remain.]

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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