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Are ETFs Really Safe? An Interview With Andrew Bogan

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Submitted by Andrew Bogan of Casey Research

Are ETFs Really Safe?

Dr.Andrew Bogan is a managing member of Bogan
Associates, LLC in Boston, Massachusetts. He has spoken at many
international investor conferences – his specialty being global equity
investing – and has been interviewed on live television for
CNBC's Strategy Session.

In an attempt to understand the
relatively new but wildly popular Exchange Traded Funds (ETFs), Dr.
Bogan did extensive research into the structures used by ETF operators,
with a special focus on the potential risks that might arise should they
be faced with large and sudden liquidations. Given that there are about
2,000 ETFs in existence, with assets totaling over $1 trillion, we
thought it appropriate to find out what Dr. Bogan has learned in his
research.

David Galland: Our primary goal
today is to give readers a better understanding of exchange-traded funds
(ETFs) and the risks that come with them. Speaking personally, I've
been in this business for a long time, and I find anything that grows as
quickly as ETFs have a bit worrisome.

To begin, maybe you could just talk a little about the difference between an ETF and a traditional stock or bond mutual fund.

Andrew Bogan:
Yes. Shares in a traditional mutual fund, whether it's an index fund or
has a managed portfolio, don't trade in the open market. If you want to
own shares, you buy them from the fund. If you want to get rid of your
shares, you sell them to the fund.

A traditional mutual fund takes
its shareholders' capital and invests it directly on a one-to-one basis
in stocks or bonds and holds those securities in custody. Thus it's
always 100% reserved, meaning that the securities it owns correspond
exactly to the shares its investors own. If you want your capital back,
the fund can deliver it to you either in kind or in cash, depending on
market conditions.

That's not the case with an ETF. Shares in an
ETF trade in the open market, which is where retail investors buy and
sell them. An ETF also issues and redeems shares every day, like a
mutual fund. But, unlike a mutual fund, it does so only through
"authorized participants," which are brokers, market-makers and other
institutions.

DG: Jumping right to the point, has there ever been a problem with an ETF?

AB: ETFs
have operated pretty well historically, but the mechanics of share
issuance and redemption also creates some unique differences that we
believe may lead to unintended consequences.

There already have
been a few problems with ETFs, some more significant than others. The
Flash Crash on May 6 of last year showed some structural issues with
ETFs and perhaps with our whole market system for equities as well. It's
hard to decide where to draw the line, but a lot of securities departed
from their perceived value during the Flash Crash by very large
amounts. The reasons are still not completely understood, although the
SEC has made a reasonable effort to understand what happened.

Another
incident occurred in September 2008, when the Lehman and AIG mess was
upon us. The commodity ETFs run by ETF Securities, Ltd., in London
halted trading when AIG's solvency came into question. The funds were
investing in derivative contracts, including swap agreements, some of
which were with AIG. It was only the Federal Reserve pumping in tens of
billions of dollars that prevented those products from going. Bailing
out AIG averted a disaster for the funds, and they continued to trade
the next day.

DG: So, the issue with the ETF securities fund was more around the derivatives the fund held, not the structure of the fund itself?

AB: In
that particular case, it was around the derivative contracts that
underlay the fund, although that kind of arrangement is very common with
European ETFs. Even equity index ETFs in Europe tend to be structured
that way, and that's also not uncommon with a lot of the foreign stock
ETFs as well – including some of those traded here in the United States.

I
think it's a clear example where you have a counterparty risk wrapped
inside the fund that could be very significant in bad circumstances.

DG:
In the case of the Flash Crash, your research paper pointed out that
even though ETFs represent only 11% of the listedsecurities in the U.S.,
70% of the canceled trades during the Flash Crash involved ETFs. Is
there an explanation for that?

AB: Some clarity
is starting to emerge from work done by the SEC and others. But from our
perspective, those statistics are quite alarming. There's no good
reason 70% of canceled trades would be in ETFs while only 11% of listed
securities are ETFs. And even though ETFs trade more actively, they
don't represent 70% of all trading volume. So any way you look at it,
they were badly overrepresented among the canceled trades, i.e.,
overrepresented among the most extremely off-priced trades.

From
the perspective of financial theory, that makes absolutely no sense.
ETFs are meant to be index-fund trackers. They’re meant to represent a
whole basket of shares, and yet these very securities that are meant to
be diversified actually fell more than their underlying stocks during
the Flash Crash, more often and more deeply.

That's quite
worrisome; it tells you that in a crisis environment ETFs don't behave
the way financial logic suggests they ought to, which suggests to me
that the theory is incomplete. People haven’t really looked closely
enough at what the unintended consequences of ETF issuance and
redemption mechanics are, and what the realities are in stressful market
conditions.

DG: At this point, more than half
the American Stock Exchange's daily volume is ETFs, which is quite a
number. These things have only been around for, what, less than 20
years. Yet from everything I've read, it seems they’re not very well
understood, even by you guys. Which is saying something because you’ve
spent a lot of time looking at them, and there are still blank spots in
your knowledge about how they actually operate.

AB: Absolutely,
and I think that's an important point. We understand the mechanics of
how an equity trades and from where it derives its value and how it's
priced in the market. The mechanics for mutual funds are well understood
also. The challenge with ETFs is that the process of issuing and
redeeming shares that also are trading is much more complicated than a
lot of people want to talk about. It allows for some unintended
consequences, particularly in connection with short-selling, which
became an important factor only in the last decade.

DG: Let’s
talk about the process of creating new shares. If I'm running an ETF
that is designed to mimic the S&P 500 index and I have a lot of
people who want to own my fund, I can simply issue new shares based upon
the flow of stocks into my fund, right?

AB:
Shares can be created at the end of any day if someone delivers a basket
of underlying stocks to the ETF through an authorized participant. And
shares that are not wanted in the marketplace can be redeemed in kind
for the underlying stocks – or in some cases cash. That's all been
carefully structured and works smoothly. The issue is what happens when
short-selling dominates the trading.

People have been
short-selling ETFs up to shocking levels, like 100% short, 500% short,
sometimes over 1,000% short. That's in a world where stocks like Apple
are 1% short, or IBM is 1.4% short, or General Electric is 0.5% short.
You really don’t see traditional stocks with short positions anything
like this, so clearly something is fundamentally different. The
difference is that ETF short-sellers – including hedge funds, dealers
and arbitragers – are confident they can always create the shares needed
to cover, so they see less risk of being squeezed.

DG: But in a traditional short-selling situation, you typically have to borrow the shares before you can short them.

AB:
Yes, and that's true here too. But if you look at the Securities
Settlement Failure data, ETFs are very oddly overrepresented, so it does
look like there is some short-selling that happens before the shares
are borrowed. But that's a small matter. The problem is that there is no
limit to the amount of short-selling you can theoretically do while
still having borrowed the shares. It simply requires the same share to
have been borrowed, short-sold, borrowed from the new owner and
short-sold again down a daisy chain. That's how you get these
arbitrarily large short interest figures.

The short-selling
involves new buyers coming in without the shares being created at all,
and that's the fundamental asymmetry in the short-selling that we're
most concerned about.

DG: Let's get to that,
because you have retail investors, for lack of a better word, and you’ve
got the hedge funds. I suppose they could both own the same fund, but
for completely different reasons; a hedger to hedge another bet, and a
retail investor to pursue a certain goal, but the net result is that the
short interest is still way out of whack from what you'd expect to see
in a traditional stock. I suspect this is something that most of the
retail investors are unaware of. So, where is the potential for the ETFs
to get into trouble?

AB: The trouble could come from a number of different angles.

One
concern is that the huge short interest building up essentially leaves
the ETF as a fractionally reserved stock ownership system. If you have a
fund, for example, that is 500% net short, then for every one holder of
an actual share there are five other investors who own IOUs for the
shares. Their real shares have been lent out and short-sold to someone
else – usually without the original owner's knowledge, unless they read
and still remember the margin agreement they signed when they opened the
account 10 years ago.

For the ETF itself, it means that the fund
holds only 15% of the underlying securities implied by the gross number
of fund shares that investors think they own. The other 85% isn't
totally missing, it just isn't held by the fund.

Morningstar
commented that the money is all there, it's just in hidden plumbing in
the financial system, and we agree with that exactly. The question is,
how many investors understood they were storing their money in the
hidden plumbing?

DG: So walk us through what
might happen if there were large-scale redemptions. Let's just say that
for whatever reason, people decided this was the time to get out of a
particular fund. How do things get unwound?

AB:
Redemptions have to flow through an authorized participant, which is
usually a broker or market-maker, and it's only that institutional layer
that can actually redeem. If for some reason a significant portion,
say, half or 80% or so, of the total fund ownership wanted to redeem and
get the underlying stocks from the ETF through the authorized
participant layer, you would fundamentally have a crisis in a
fractional-reserve system.

The ETF could not deliver the
underlying stocks to all the would-be redeemers. The investors who
really owned just an IOU on shares that had been lent to short-sellers
wouldn't have a direct claim on the fund, so their demand to redeem
would force an unwinding of the short-sales.

DG: So
it seems that it's not so much the fund that might have a problem. The
fund is only liable for the shares it has issued. The risk seems to lie
in the counterparties – the brokers or the investors that brokers lent
shares to.

AB: Right. Essentially you have just
that. You have quite a bit of counterparty risk here, because if you
think your shares can be redeemed and then the fund halts redemptions
because they’re running out of the underlying stocks, you're stuck.
Normally ETF shares are redeemable through the authorized-participant
channel, but an ETF or any other institution that issues something that
is redeemable but fractionally reserved could be hit with a run, like a
bank run.

Now the big question is, in practice, would this happen?
It's up to everyone to form their own conclusion, but interestingly the
first argument we heard when we began looking into ETFs was that this
was just a theoretical topic and that there would never be a really big
redemption in a large ETF. But we have since learned that's actually not
the case, because a giant redemption in IWM, one of the largest ETFs,
occurred in 2007.

Now we think that 2007, being one of the best
markets for equities since maybe the late ‘90s, was a pretty forgiving
time to test the crashworthiness of an ETF that runs into a massive,
unexpected redemption. But IWM was redeemed from millions of shares
outstanding down to something on the order of 150,000 shares, and in one
day, and that's because somebody tried to crash the fund.

DG: Was that a really lousy fund, and somebody just said, "Enough, I'm going to punish you guys and get out of it,” or –

AB:
Oh, no, no, IWM is one of the largest and most liquid ETFs in the
entire market. It's the Russell 2000 iShares ETF. It is the poster child
of why ETFs are great. But even so, what's interesting is that the
first argument we got from industry insiders was that our misgivings are
nonsense, growing out of some theoretical conversation about what might
happen but is never going to happen, and now we're being told it
already has happened and nothing broke too badly, so what are we worried
about.

DG: Let’s stick with this potential
problem of a huge bunch of redemptions. People say, "Oh my god, I've got
to get out of my ETFs," and there is a wholesale run on the funds.
Because of the way ETFs are structured, it would seem that if they post
net redemptions for a day, that the broker that had lent fund shares to
short-sellers would just force the borrowers to buy back and cover their
obligations.

AB: That's exactly right, but
remember, for an ETF to create units requires someone to deliver the
underlying stocks, so there's somebody who's on the hook to buy those
stocks en masse all at the same time.

DG: No matter what has happened to the price in the interim.

AB:
Yes, which gives rise to the question of who's on the hook and what's
their creditworthiness when they get put on the hook. Have their prime
brokers really been keeping appropriate track, as they’re required to do
and on most days have done, of the creditworthiness of those, say,
hedge funds or other kinds of short-sellers?

DG: Because you're not talking about small amounts of money.

AB:
No. In fact, in one ETF, IWM again, short positions recently amounted
to 14 billion dollars. That's not an enormous amount for the capital
markets, but it's a pretty significant amount with respect to 2,000
small stocks. If there were a run, actually doing that unwind and
getting those 14 billion dollars' worth of extra ETF shares would
require buying 14 billion dollars’ worth of Russell 2000 stocks. If you
didn’t want to be more than, say, 10% of volume, it would take 40
trading days to buy all you needed.

So we think that if you
actually had a very sudden redemption run on IWM, there is a real
likelihood of a short squeeze occurring in the Russell 2000. We don’t
expect that at any particular time, it's just something that could
happen if enough things went wrong.

The short position in an ETF
like IWM being over 100% means that a large amount of the money
investors think they have placed in Russell 2000 stocks has in fact been
lent to hedge funds and other short-sellers. You take that across the
entire ETF industry and you're looking at about 100 billion dollars in
short interest – money that did not go into the underlying shares or
gold or whatever the ETF represents. It was instead lent to hedge funds.
It has been deposited in a shadow banking system where ETFs allow
short-sellers to borrow money from institutional and retail investors.

DG: And what are they doing with that money?

AB:
Well, no one knows. Presumably they invest it in what they think is
going to make a better return than what they shorted, because you can't
score the 10% or 20% those guys are all trying to make every year by
buying the index. So it's anybody's guess.

DG:
One question that Terry Coxon asked as I prepared for this interview was
whether there is any way for the marketplace to let the fund's share
price deviate for long from NAV?

AB: The tracking
of an ETF's price with the fund's NAV, which historically has been
extremely close, is totally dependent on an arbitrage mechanism. The
arbitrager can make money by continuously pushing the price of the ETF
toward its NAV. The question is... what NAV? What they mean by NAV is a
value per share outstanding of the fund's underlying stocks. But of
course you have this huge implied ownership through short-selling, and
the short-sellers' shares are not being counted in the shares
outstanding number.

DG: A lot of our readers have
money in GLD, which is the ETF that invests in physical gold. You've
looked at GLD, and it's based upon the premise that as investors pour
money in, the operators of GLD turn around and buy physical gold and
store it. And likewise with redemptions, they just sell the gold. My
understanding is that there isn't anywhere near the same level of short
interest on GLD.

AB: The short position in GLD
isn't nearly as large as it is for some equity funds – but we have
looked at GLD, and it has the same structural issues, just to a lesser
extent, at least for now. The short interest in GLD has fluctuated
around 20 million shares. Now, GLD is a pretty big fund. With 20 million
shares short, it is roughly 95% fractionally reserved. So for all the
investors who think they own the underlying physical gold, the fund
actually has 95% of it in the vaults.

But GLD does not have to
stay at 95% fractionally reserved. If there were a massive wave of
short-selling in GLD, you could end up with a very significant
fractional-reserve situation. If that were followed by heavy
redemptions, you'd have the same kind of problem I described earlier –
not enough gold to redeem all the shares.

DG: Could they just say, "From here on, we're not issuing any more shares"? Would that stop the short-selling?

AB:
Not necessarily, because, you know, the short-sellers are selling – in
fact, it would probably exacerbate the short-selling. So as long as a
fund is issuing shares, aggregate buying demand can be satisfied by
expanding the fund. If they stop issuing shares, aggregate demand would
get satisfied by short-sales of existing shares. So, if anything,
closing the issue window should make the problem worse, not better.

DG:
Working through the mechanics of this, let's say gold drops by a few
hundred bucks. Say, for instance, that there is some major change in the
market along the lines of when Volcker raised interest rates back in
'79-'80. And at that point a lot of short-sellers say, "Okay, this is it
for gold," they pile on, they start shorting the hell out of GLD, and
now all of a sudden you’ve got a real problem because the fractional
aspect of it balloons, if you will.

AB: Well, you
don’t necessarily have an immediate problem. It depends on the market
conditions and the level of panic. You certainly would have a ballooning
fractional-reserve situation, meaning that the reserves held in actual
gold versus the implied ownership by people who think they own GLD (even
though the shares have been hypothecated by the broker) will shrink.
Those investors may believe they are still entitled to the metal, but
the reserve of gold held on their behalf starts to shrink very quickly
under those conditions.

The bigger challenge might be if there
were an actual redemption wave. If that happened when GLD was already
substantially fractionally reserved, then you're back to an 1800s gold
bank problem. Fractionally reserved banks can be hit with a run.

DG:
Right. Is there anything else that would make this whole "house of
cards" collapse? Suppose a highly visible ETF stumbles and is unable to
meet redemptions, or they just have to postpone redemptions. That might
be the sort of trigger that could really send people off.

AB:
You know, one of the big risks, by the way, that no one has really
discussed much, is if an ETF were to have a big redemption run in
panicky market conditions and halted redemptions. Halting redemptions is
a complicated decision, because it breaks the symmetry that allows the
arbitragers to go long or short both the basket of stocks and the ETF
shares to move price toward NAV.

So it's quite possible that if
redemptions were halted for any length of time, the arbitragers wouldn't
be keeping the share price in line with NAV. We already know from the
Flash Crash that significant price departures from NAV are quite
possible for ETFs.

DG: Knowing what you do, I
mean, obviously you deal on an institutional level with your
money-management firm, do you own ETFs personally?

AB: We do not. We do not own any ETFs either personally or on behalf of the funds we manage.

DG: Is it because of the research you’ve done or just because it's not what you guys do?

AB: I
would say it's primarily because it's not part of our strategy, but
obviously we did the research because we were interested in
understanding the product better.

DG: So, any advice for readers? Is there a short interest over which a person should be concerned about his holdings?

AB:
Well, I don’t know if I could set a threshold, but I would certainly
encourage people to make sure they know what the short interest is in
any fund they are considering. That's a metric that is starting to
become more accessible. Since we published in September, some of the ETF
sponsors, like BlackRock, have begun reporting on ETF short interest,
which I think is terrific – kudos to those guys. We would like to see
better transparency and disclosure, so that institutional and retail
investors alike are aware of the counterparty risks that are "hidden in
the plumbing," to use Morningstar's term, and are aware of the actual
and somewhat complicated mechanics of the products that they’re buying.

DG:
Do the ETFs with a mandate to magnify an index 2 or 3 times (e.g., RSW)
have an elevated level of risk, due to the additional leverage? 

AB:
The underlying "assets" from which these funds get their NAV are
derivatives to begin with, which introduces another layer of
counterparty risk – one that has already experienced serious
problems. We find it surprising that packaging complex derivatives in an
exchange-listed security (the ETF) seems to remove all of the
sophisticated investor standards usually applied to derivatives trading
by SEC, CFTC, etc.  

One ETF recently launched in the U.S. is PEK,
the Market Vectors China A Shares ETF. This is another great example of
where the industry is headed.

It is illegal for most foreign
investors – except a few licensed global institutions – to buy A shares
on Shanghai or Shenzhen, China's two mainland stock markets, and Market
Vectors is not one of the exceptions. So instead of owning A shares, the
ETF owns swaps with brokers that are licensed in China to own A shares.
The fund holds the swaps as its underlying "assets." So PEK is an
NYSE-listed China A shares ETF that does not own a single Chinese A
share.

If PEK were to become significantly short in the secondary
market, it would mean a fractional-reserve ownership of a derivative
representing a basket of stocks that would be illegal for nearly all of
the ETF's investors to own directly. More confusing still is what it
means to be short PEK in the first place, since it has historically been
illegal to be short A shares in China at all.

In essence, ETFs
are being used to package and securitize products that are at best
poorly understood and in some cases are used to circumvent securities
regulations. An example closer to home is when the SEC briefly banned
short-selling of essentially all financial stocks in 2008. The
financial-sector ETFs were not on the list, so many hedge funds kept
right on shorting financials using those ETFs.  

DG: Certainly a lot to think about here. Any other questions I forgot to ask about, but that I should have?

AB: No, I think that was a pretty good coverage of a little bit of work we've done.

DG:
Is there a good publication that would help people better understand
the mechanics of the ETFs, because it is obviously very complicated,
something that people might want to be able to study?

AB: Always
the best place to look is in the fund's prospectus. The prospectuses
are long and impenetrable, because they’re written by the legal team,
but they really do have a tremendous amount of information. If you can
float through one of them, I think it's definitely to your advantage.

DG: Thank you for your time.

 

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Mon, 04/11/2011 - 20:59 | 1159899 Joe Grannville
Joe Grannville's picture

After reading this blog, I just sold all my silver and gold and bought blue jeans and black beans.  I'm gonna make a killing.  I figure I'll sell the jeans and eat the beans.  I've got it made.

Tue, 04/12/2011 - 12:30 | 1161915 Thomas
Thomas's picture

CEF's NAV is back to essentially even. Swapping out SLV and GLD for CEF (I did the reverse years ago) might be logical.

Mon, 04/11/2011 - 21:04 | 1159913 SwingForce
SwingForce's picture

Casey can Research my bowels for green shoots, have fun. Nothing is safe asshole.

Mon, 04/11/2011 - 21:53 | 1160025 jedimarkus
jedimarkus's picture

Accenture hitting a penny on last year's flash crash was the big message that SwingForce points out here.  NOTHING IS SAFE.  it is all paper crap in fiat currency....

Mon, 04/11/2011 - 21:04 | 1159921 IQ 145
IQ 145's picture

 There's no reason for an ETF to exist; and there is certainly no reason for a retail investor to be involved with one. It is merely a product that has been created so that "marketing" could create a "consensus"; aka brainwashing, or advertising could take effect. Forget about the alphabet soup; don't even think about options; study the commodities futures contracts; that's where the money is made on the underlying.

Mon, 04/11/2011 - 21:10 | 1159929 Reese Bobby
Reese Bobby's picture

So you think gold futures are backed by deliverable gold?

Mon, 04/11/2011 - 21:11 | 1159935 Joe Grannville
Joe Grannville's picture

I have to respectfully disagree.  I've been long AGQ calls since December and made enough to finance Tylers Klonopin bills for eternity.

Mon, 04/11/2011 - 21:26 | 1159969 Reese Bobby
Reese Bobby's picture

I'll grant you funny.  But you own calls on forwards and futures.  That may be a poor play at some point.  But I'm glad you made a killing.  I just hope JP Morgan will be o.k.

Mon, 04/11/2011 - 21:38 | 1159996 Joe Grannville
Joe Grannville's picture

I did clean up but I'm being blatantly sarcastic.  With all the depressing shit Tyler regurgitates here daily he must be hooked up to a Prozac beer funnel. 

Mon, 04/11/2011 - 21:46 | 1160010 Joe Grannville
Joe Grannville's picture

In other words, see the dude for what he really is.  What parent gives their child a snake when they ask for a loaf of bread.  He's a spirit crusher making money off his sponsors.

Mon, 04/11/2011 - 21:49 | 1160023 Reese Bobby
Reese Bobby's picture

You lost me there.  Tyler and ZH provide education and perspective you will find nowhere else.  But good luck Prozac guy.  It sure is sunny out today!!!

Mon, 04/11/2011 - 21:56 | 1160032 Joe Grannville
Joe Grannville's picture

 "It sure is sunny out today!!!"

I like to think so too but it's NEVER sunny in Tylerville.

Read this blog for a week and you'll be jumpin' out your basement window!

 

 

Mon, 04/11/2011 - 23:29 | 1160377 Astute Investor
Astute Investor's picture

Why is it when I click on your "name" I receive the message "Access denied - you are not authorized to access this page"?

Tue, 04/12/2011 - 11:46 | 1161719 w a l k - a w a y
w a l k - a w a y's picture

joe disappeared

Mon, 04/11/2011 - 23:27 | 1160385 superflyguy
superflyguy's picture

I look at it differently. I get the information about the real world, not the MSM painted one. That way I can prepare and decide where to put my hard earned money and where to live.

Without this site, I'd probably be like my friends, buying a $900k house which I cannot afford but it's OK because the economy is getting better and the housing market is recovering.

 

Tue, 04/12/2011 - 19:10 | 1163329 mkkby
mkkby's picture

Thanks for your contribution, and very funny, asshole.  Go back to watching CNBC and drinking all your government issued cool aide.

Mon, 04/11/2011 - 22:08 | 1160055 tickhound
tickhound's picture

For many Prozac just isn't necessary... For them, "Goldilocks", "subprime containment", and "Dow 36,000" provide similar required effects.

So, for you, "the fundamentals of the economy are sound."

Feel better, jackass?  I do. 

Mon, 04/11/2011 - 22:03 | 1160050 Manthong
Manthong's picture

I've been toying with the idea of a little AGQ daily or at the edge just for excitement, but I'd like to know if anyone thinks that the big premium on PSLV really buys you anything long.

Mon, 04/11/2011 - 21:11 | 1159931 squexx
squexx's picture

If you do play the ETF game when the market finally does drop, don't play long. The underlying fundimentals of the ETF's are based on derivitives as well. Like a house of collapsing cards. Get out early and let the hogs get slaughtered when the ETF's do start to fall apart.

Mon, 04/11/2011 - 21:35 | 1159991 Id fight Gandhi
Id fight Gandhi's picture

I only see them as trading vessels nothing more. At that point why buy them when you can get same exposure with a deep ITM call with high delta.

Vxx ung, uco all have traded like shit. Forget leveraged ones.

Tue, 04/12/2011 - 06:08 | 1160845 ZeroPower
ZeroPower's picture

Wrong, ETFs are the derivative, based on the underlying.

Mon, 04/11/2011 - 21:13 | 1159942 MadT
MadT's picture

"a lot of securities departed from their perceived value during the Flash Crash by very large amounts. The reasons are still not completely understood, although the SEC has made a reasonable effort to understand what happened."

bullshit to follow. no need to read more.

Mon, 04/11/2011 - 21:17 | 1159949 Kurtieboy
Kurtieboy's picture

Bottom line is any time you give your money to another party to manage, you are taking a risk.

Mon, 04/11/2011 - 21:19 | 1159951 Misean
Misean's picture

Welcome all my friends

to the show that never ends...

Just another casino game to loot the 401K's.

Mon, 04/11/2011 - 23:25 | 1160384 Paul Bogdanich
Paul Bogdanich's picture

"Just another casino game to loot the 401K's."

 

Really.  That no one could have forseen or perdicted I might add. 

Mon, 04/11/2011 - 21:26 | 1159972 MrBinkeyWhat
MrBinkeyWhat's picture

Safety is such a relative concept. I have followed Casey Research for a while from LRC. If you really want to "feel safe" you have acquired your farm land, guns, ammo, silver, stored food,training, friends, etc...a while ago. the rest of you are "sheeple".

Mon, 04/11/2011 - 23:38 | 1160424 ceilidh_trail
ceilidh_trail's picture

Farmland may not be so safe with Japan nuke fallout raining down...

Tue, 04/12/2011 - 01:58 | 1160694 Spitzer
Spitzer's picture

FARM LAND IS A FUCKING JOKE !

What do all of you retards think farmers have been doing for the last decade ??

Bidding up the price of farmland of course. They have just as low of interest rates as everyone else. I have seen it with my own eyes. There is land flippers just like condo flippers. The shark farm land realtors fly farmers around to view land in their helicopters.

Every since that douche Buffet said "farmland" there has been this stupid idea floating around that all the farmers some how where not subject to low interest rates.

Tue, 04/12/2011 - 08:48 | 1161118 boooyaaaah
boooyaaaah's picture

Farmers are not stupid either
They do futures regularly
They never give a sucker an even break

With this naked shorting of etfs
They will make the tide go out
All boats will fall

If you want more info on naked shooting see ostk on the
Investor village bd
And then to deep capture

The CEO of ostk, Patrick Byrne is bringing the prime brokers to trial.
For naked snorting his company's stock.

Mon, 04/11/2011 - 21:28 | 1159974 web bot
web bot's picture

Bogan says several times... "according to the theory". Could it just be that the market has realized that some of our fundamental theories about markets don't work with you inject almost $2Trillion into the system???

Mon, 04/11/2011 - 21:31 | 1159983 Greenhead
Greenhead's picture

I would be shocked if 1 in 1000 retail investors really had a clue about the inherent risk in the structuring of many of these products.-1

Mon, 04/11/2011 - 23:35 | 1160411 superflyguy
superflyguy's picture

If it was only investors... I had an argument with one financial advisor about how these products are not safe and he said that I don't understand them, lol. I really feel sorry for his clients. I do see another Lehman coming...

Mon, 04/11/2011 - 21:34 | 1159984 Jreality
Jreality's picture

Does ETF stand for Easy To Fail? 

Mon, 04/11/2011 - 23:46 | 1160448 IQ 145
IQ 145's picture

 Actually it stands for "easy to buy"; although the letters don't work out so well. These products were created by business school graduates who were very aware of the millions of dollars in brainwashing that had already gone into forming the "American Consensus"; that everyone should be in the stock market. they knew that "everyone" had a stock trading account, and that they would buy these things, because they were traded on the Exchange; the broker can flog them over the phone, and you already have the stock trading account. Everyone "knows" that you'all lose all your money when you go into the commodities futures trading business, but ETF's are friendly and familiar; they're just stock market alphabet soup. So, basically, these products, all of which contain various layers and types of risk that you are not aware of; are "Duck Feed"; and as my friend in Chicago used to say, "If you like to peck up duck feed and quack, you must be a duck". There';s no reason to own an ETF.

Tue, 04/12/2011 - 06:13 | 1160849 ZeroPower
ZeroPower's picture

Your argument instead is: "theres no reason to own equities" rather than any particular (or all) ETF.

For one who managed to pick the bottom at some point in 2009 with a plain vanilla long index ETF, i can assure you their accounts are indeed richer (yes, in fiat) by a fair amount.

That is the reason to own an ETF. Whether there are inherent risks to holding, of course, as with ANY single equity on any world wide market. Thats not the issue however. You can make a case for levered ones being horrible investments; you can even extend this to ETFs which, according to the blogosphere, are not backed by what they represent; but it rather naive and shortsighted to say owning a SPY or QQQ is for brainwashed suckers.

Mon, 04/11/2011 - 21:36 | 1159995 Id fight Gandhi
Id fight Gandhi's picture

I really wonder if slv and GLD really hold the true amount of metals they say they do.

Mon, 04/11/2011 - 22:24 | 1160095 aphlaque_duck
aphlaque_duck's picture

If you read the prospectus for GLD you'll find they explicitly disclaim such representations. I forget the exact wording but basically amounts to that the gold is not guaranteed to meet standards for deliverability and if any problems are found with the assets then the losses will be borne by the shareholders. And there are many other weasel clauses which, taken as a whole, basically would allow the entire instrument to be a complete fraud leaving no recourse for the investor. I used to hold GLD for brief periods of time as my "dry powder" but now after studying the prospectus, I don't touch it.

Mon, 04/11/2011 - 23:30 | 1160400 Id fight Gandhi
Id fight Gandhi's picture

I remember someone on seeking alpha caught a sketchy inventory write up on one of these metal funds. I forget who or which metal but it was last year.

These are trades no replacement for physical.

Tue, 04/12/2011 - 02:23 | 1160715 Manthong
Manthong's picture

It was PSLV. Sprott published arrival of metal contracted for delivery into the fund and the article used that fact to say "see, they don't have everything they make you think they do". I still would like someone in the know to lay out what, if anything, separates Sprott PSLV and PHYS from the others and justifies the premium and the latency in pricing.

Mon, 04/11/2011 - 23:50 | 1160454 IQ 145
IQ 145's picture

 All I can tell you is if I was in charge of it; every ounce would be leased out to some un-identifiable international entity based in Bahrain. But then, I'm not really a nice guy. Maybe they are.

Mon, 04/11/2011 - 21:47 | 1160007 CPL
CPL's picture

From my blog when I cared about it.

 

These are only recommendations on how to approach X3 ETF's. I cannot stress enough how important it is to maintain disciple on using them. For a day-trader, these are the equivalent of a nuclear arsenal, and are just as friendly. Treat them with care and a light touch. So a good list of general rules on nuclear ETFs is needed.

  • You don't hold them longer than a couple of hours. They move like lighting, up and down, which mean you need to be prepared to sell your position to save your ass.
  • Don't hold over night ever. As in NEVER ever. Don't. Did I mention don't do it. Nyet. Non. No. Nien! Don't do it. You will thank yourself later.
  • If you are stuck in a position, wait for the past 3 week high or low on the Russell index you are connected to. Waiting for a 52 wk high or low price point on a leveraged ETF is like waiting for a train in a ghost town, the train is never going to come. Learn how to average down and when the opportunity arrives to get the hell out, do so. (DO NOT LISTEN TO THIS POINT, LEARNED HARD WAY...)
  • Don't get greedy. Two years ago anyone of us would have given our left nut for a 5% in a day let alone a quarter. 5% on these things means you buy a deal, not buy first thing in the morning. Never buy anything or accept anything but the price that you want. If you went to a cafe and asked for a coffee and toast and they brought you a Daquiri and Red Snapper, I don't think you would be very happy. Take the same approach with a stock, you are buying yourself something, dont second guess your choice. You select your price and hold it. If you want to gain a little confidence on picking a price don't use real money to do it. Try using a simulator like vse.marketwatch.com to practice discipline. It's tied to the real market, except you do the trades with funny money. It's like playing with stocks with monopoly money.
  • These are based on the RIFIN.X/RIENG.X/RUJ.X/RLG.X. Not the DOW, DJIA, Or British stocks, Or Canadian beavers, Or Japanese noodles. These are US stocks in the Russell index which are sort of similar. I suggest you read up on what the Russell is before putting one penny into a leverage ETF because a lot of people make the mistake of looking at the DJIA or S&P, then getting very upset when their timing fails. Their assumptions were wrong and they end up losing their shirts.
  • Go read this entire section. http://www.direxionshares.com/education.html. Again, dont invest a penny until you finish and understand it completely. The scary thing is Direxion states that these are not long term, so gain. DON'T HOLD OVERNIGHT. I might as well state that instead of don't go long. If this rule is obeyed then you wont have to worry about going long. Going long on these is breakfast to lunch.
  • These are leveraged ETF's which means they, FAS and FAZ, ultimately lose value over time into the negatives. Again no going long! You'll be 3% poorer every week, well averaging from the inception of these things. It's called a leverage trap and there are people stuck in the hole for a couple of hundred grand because they assumed these are buy and hold stocks. Which they are not. There are X3 ETF's and are deadly to a trade account if you don't understand what you are looking at.
  • Buying these things in no way boosts the financial sector. ETFs, especially leveraged ETFs are built from dragons breath and pixie dust. I wish I were kidding but for all reasonable purposes these are the Mallobars of the trading set, however destructive. All sugar and no nutrional value other than sugar. So when you are buying an ETF, you aren't buying and selling because the rules of supply and demand. You buy and sell against the Russell. Not the other way around. Makes a huge difference in how to approach these beautiful and danagerous beasts.

This concludes our lesson in the care and treatment of your ETF. Make sure to pet it everyday, let it out at night and don't let it in until it has brought you what you want.

Mon, 04/11/2011 - 22:06 | 1160052 Id fight Gandhi
Id fight Gandhi's picture

Has anyone short both a long and short triple ETF and pocketed the decay successfully?

Mon, 04/11/2011 - 22:18 | 1160082 CPL
CPL's picture

I thought about it, unless you are flipping a billion dollars the numbers aren't worth any of the risk.  The leveraged decay in both directions...both...eat profit either way.  You cannot do any DTM (Denis The Menace) trading on these.  DTM is strictly forbidden...always...nyet...non...no...don't.  Cannot STRESS ENOUGH...just no.

 

Although, if it's a market "happy day".  You'll make more in the bear ETF drop.  Switch direction on drops.

 

Shorting pays more than holding either direction but you have to play with the market movement.  Mainly because hold long against a bull or a bear, you are still working against leveraged decay.  Always let the leveraged decay play.

 

Dangerous thing about both directions is when the fuckers spilt the shares with zero announcement.

Mon, 04/11/2011 - 22:13 | 1160072 gordengeko
gordengeko's picture

Great interview ZH and thanks for posting the rules CPL.  The market not even mentioning options and volatility are hard enough to comprehend.  Now throw in triple leveraged ETF's, with options.  This whole friggn market is like a giagantic shitbomb ready to implode or it could just very well expand forever and ever, just create new shit and call it something fancy then make sarcastic etrade commercials making fun of the average retired sheep trying to trade their IRA in this scam shadow casino.

Mon, 04/11/2011 - 22:23 | 1160101 CPL
CPL's picture

Sad to say...that's pretty much the size of it.

Mon, 04/11/2011 - 23:50 | 1160457 ceilidh_trail
ceilidh_trail's picture

 Nice job CPL. I wish I would have read this last summer. NEVER would have touched VXX- crappiest buy I have made in a long time...

Tue, 04/12/2011 - 00:33 | 1160542 CPL
CPL's picture

Leveraged ETF trading is dumb idea on the best of days.  You have to be completely wacked out of your mind to do it and have the reaction speed of a viper/tools that work faster than a viper to do it properly plus understand the conditions to need to make a trade in them.

Plus you have to have the ability to absorb thousands of dollars of losses in a single session.  Again.  Stop loss is a penny less on buy value and you trade in 10k blocks (trust me the fill on the x3's on the called price is instant, 1/4 of the market centers around a couple of ETF's, all of them X3's).

 

Again...add Insane, Fast and the ability to lose a couple of grand without flinching to the list I posted.  Longest I hold any of these is around 20 seconds to around ten minutes.  10k blocks I can jump in and out.  Plus ...god knows why...lots of dumbasses leverage an already leveraged trade by trading in margin and do the stupidiest thing ever.  They go all in.  Makes it easy to short though.

 

Only thing easier is using Tim Skyes Shorting the crap out of dump hole Pharma companies and shit hole Chinese dumps.

Mon, 04/11/2011 - 22:05 | 1160045 nonclaim
nonclaim's picture

ETF is what killed fundamentals. Knowledge of a particular company, specially what used to be low volume/obscure, is worthless since it now goes where the basket goes.

Well, if it wasn't that the sea of liquidity would have killed it anyway...

Mon, 04/11/2011 - 22:22 | 1160096 Misean
Misean's picture

Aye, the rising and roiling sea of liquidity raises all boats, capsizes them, then slams them into the rocks.

Mon, 04/11/2011 - 22:15 | 1160079 Hollywood
Hollywood's picture

You know what throws me for a loop every time I read about this type of thing is the whole idea of cancelled trades.  Why can't I cancel my trades?  If I set-up the trade, then I need to live with the circumstances created by my actions.  Instead, the trades are cancelled?  I know, I know this has been discussed before, but it just gets me...every time.

Mon, 04/11/2011 - 23:26 | 1160374 Id fight Gandhi
Id fight Gandhi's picture

The earliest I can remember this being done on a regular basis was the last couple years. Has it ever happened earlier? Has anyone had a good day trade flip where you bought or shorted then dumped it quick for a profit to have it all cancelled?

Tue, 04/12/2011 - 02:57 | 1160732 slewie the pi-rat
slewie the pi-rat's picture

i don't know the answer to the Q. 

but i sure like the question!  my sense is that it might not have happened during the specialist era, when actual people stood at various posts on the floor, placed the buy and sell orders in their book, and made a market, the market, in the stock(s) of their specialty. 

you could see these licenced specialists on t.v.  i always thought it was quite theatrical, for some reason.

when a specialist crossed a trade, it was crossed!  til about 2006, i think.  they reorganized and recaptialized, and remade the whole situ, in many ways. 

but, there were times when the "back room paperwork" got backed up pretty bad!  automation was late in some ways. 

Tue, 04/12/2011 - 00:22 | 1160283 CPL
CPL's picture

Yay spam is gone!

 

Mon, 04/11/2011 - 23:28 | 1160390 SAME AS IT EVER WAS
SAME AS IT EVER WAS's picture

Mon, 04/11/2011 - 23:32 | 1160399 atlee
atlee's picture

Been long AGQ since august at 90. Today it is 254.30 and hit a high of 269.

How many mindless idiots have made a boat load just buying and holding SPY? Fact is in a bull mkt the long EFT works great. It is the double shorts that have been sucking ass. I am certain that a lot of $ has been made holding short postions in ZSL and SPXU. I have also had some very profitable trades in both TBT and TBL. When the SHTF we are all screwed regardless of what you are holding. Period. This article is just another POS analysis from someone with no skin in the game.

Tue, 04/12/2011 - 03:25 | 1160749 slewie the pi-rat
slewie the pi-rat's picture

well, maybe d. gallant, the interviewer has no skin in the game.  i don't know.  when did skin in the game becoma a prerequisite for discussing market instruments, counterparty risk, or shorts? 

dr b. cerainly has skin in the game!  he;s one of the managers for his company, asswipe!  he doesn't use ETF's.  i imagine he prefers mutual funds and equities.  skin in the game?  what a fukin asswipe!

can't you read, you little shithead?  what do ya think of the ETF CARRY TRADE = up tp $100 Bn.  they dicuss here?  did you publish that shit lasy year, you viscious little asshole?  huh?

Tue, 04/12/2011 - 00:21 | 1160500 New World Chaos
New World Chaos's picture

I know PSLV is a closed fund, but what is to stop JPmorgan from creating one offshore shell company to short it 10x over as described here, while another shell company goes in to redeem the counterfeited shares for real silver?  Even if they require physical share certificates to redeem, this seems like a way to get a good fraction of the shares without driving up the price.

BTW, I think the whole DTCC will ultimately implode due to massive naked shorting and all the little people will get killed and class-action lawyers will squabble over their carcasses while the hyperinflation rots away the settlement value of their counterfeited shares.  This is part of the NWO's endgame for America.  Dow/Silver to 1.

Tue, 04/12/2011 - 00:53 | 1160590 rlouis
rlouis's picture

My favorite ETF non-sense is the QID during the flash crash;  an index short that actually went down in price when the market tanked.

Tue, 04/12/2011 - 03:19 | 1160745 BeerGoggles
BeerGoggles's picture

IS there an MP3 for this interview, I can't be arsed to read it.

Tue, 04/12/2011 - 05:06 | 1160799 Jack Sheet
Jack Sheet's picture

sure I'll do you one for $100 - do you want it spoken, sung or farted?

Tue, 04/12/2011 - 06:23 | 1160857 mogul rider
mogul rider's picture

A derivative of a derivative that may just be a derivative of a derivative.

Gee sounds good to me. Where do I get me some of that there good ETIF.

And we wonder why apocolypse's happen. It couldn't be our own doing.

NAH!

 

I can't wait for the CNBS'ers 2 years from now showing news flashes that all ETFs are in fact scams made up by the banksters to allow for another run rate into the squid's pockets.

 

News at 11

Tue, 04/12/2011 - 06:34 | 1160863 mogul rider
mogul rider's picture

So let's review

1. ETF's are a figment of some bankster's secretary wet dream to get suckers into which in fact do NOT represent the market they are investing in. In fact they slowly suck the capital from the loser as they bathe in sun in Florida. When they get back they are now broke since ETF investments eventually go to zero.

2. You can always just buy the stocks you like, short the stocks you don't, buy stocks pumped around here as legitimate winners.

3. Buy real estate which you can touch feel and do something with = like rent it.

4. Buy the precious - touch it, feel it, barter, store, watch it go up everyday in value. Go to Zero Hedge and talk to others tinfoil hat nutjobs who see value in a 5000 year old store of wealth that if bought properly without leverage will never lose value relative to the economy it represents. It's price is reflected in the value of the time you value it.

 

hmmm these are tough choices

 

Tue, 04/12/2011 - 07:26 | 1160924 gamingthemarket
gamingthemarket's picture

Any ETF that debuted after 2007 trades in swaps.  And if you bought FAZ during the Flash Crash you lost money.  Essentially a no-bid market in 256 ETFs happened that day.  We will see it again with the bonus of a 10 day lockout.  Read the prospectus on ETFs like VXX.  Trading can be halted for ten days while counterparties figure out the real value.  Once supporting HFT bids get turned off many ETFs will go no-bid.  This mechanic is similar to the no-bid market in MBS swaps in 2008.

For traders who want a juicy technical look at the mechanics of ETFs you can find it here:

http://www.gamingthemarket.com/financial-armageddon-zombies.html

Tue, 04/12/2011 - 11:05 | 1161594 ZeroPower
ZeroPower's picture

Excuse me, but there is so much wrong with your post, ill just have to say "wtf".

ETFs can be backed by physical or sythentic underyling. Im not sure where you got this 2007 number from, but basically the creation of ETFs depends on the funds which owns the right to each family of ETF. I.e. iShares mostly structures physical ETFs; another house like DB (x-trackers family) prefers the swap-based approach.

ETFs can only go no bid if ALL retail and all machines pull out of that particular ticker. Could happen, but rather unlikely.

Wed, 04/13/2011 - 00:49 | 1164190 gamingthemarket
gamingthemarket's picture

"Under existing regulations, a new ETF must receive an order from the Securities and Exchange Commission, or SEC, giving it relief from provisions of the Investment Company Act of 1940 that would not otherwise allow the ETF structure. In 2008, however, the SEC proposed rules that would allow the creation of ETFs without the need for exemptive orders."

The ETF market was deregulated just like everything else.  The unregulated OTC derivatives market is what drives price.  I challenge you to find a single ETF, crated after this provision, that is primarily based on a basket of stocks.  I can't find a firm with hard data, but my research finds 90% of all ETFs with massive derivatives exposure.  A major interest rate or currency swap blowup has a high probability of creating a no-bid market in the majority of ETFs.  Even if this was not the case, the indexes are so dominated by a few key stocks that diversification is now laughable.

Tue, 04/12/2011 - 09:08 | 1161195 boooyaaaah
boooyaaaah's picture

Patrick Byrne -Ostk- Deep Capture. Video on naked shorting
GS trial This December.
DTCC

Tue, 04/12/2011 - 12:51 | 1161984 CustomersMan
CustomersMan's picture

 

           Whole Other Aspect : Personal Experience

 

              Law carries little weight today, agreed?

 

              If in a crisis, me as an individual (with a large mega-account, hedge fund) or more likely one of the "connected-firms" on Wall Street, or a trader for one of the "firms" who wants to be a hero, etc. wants to be "instantly" short-the-market across the board, or in a particular sector,

 

             Bang, There it is.

 

        The people buying this stuff, believe the marketing material. They also believe the rules and the laws governing the set-up and functioning of these funds , the exchanges, and managing will be followed.

 

         But, the "firms" have legal Dept's and they set these up, and they know how to use them in a crisis.

 

          They could also be used and are to go instantly "long".

 

 

 

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