Gil’s Musings

Disingenuous ETF Arguments

Any routine reader of this blog will know I’m a fan of Exchange Traded Funds (ETFs). ETFs are fast becoming the world’s most popular investment product. The king’s crown of most popular product still belongs to active mutual funds, but ETFs are on pace to dethrone them.

With rare exception, ETFs are far cheaper to own and have much lower tax drag than most active mutual funds. Most mutual funds are also sold for a commission by the largest sales force, the million or so stockbrokers in the US. The big brokerages (Merrill Lynch, Morgan Stanley, et al) along with the big active fund families (Fidelity, Dreyfus, et al) generally find ETFs are eating their lunch. The reasons are many; mostly indexed construction (eliminating typical fund underperformance); generally lower cost (sometimes by 40x lower); and better tax treatment (often zero declared taxable gain on a 1099). You can clearly see why a near wholesale shift is underway. But this has not come without the typical gnashing of teeth, as you would expect from those being supplanted.

While ETFs have long been used as a strawman to saddle with blame for a myriad of the market’s quirky behaviors, it’s often sour grapes behind the motive to discredit ETFs in order to sow doubt. It is not general structural flaws with the ETF industry as many would love for you to believe. With volatility now spiking and some ETF involvement, you should now brace for an entirely new wave of writings attempting to hang the noose on ETFs. As with any misleading argument, there are typically threads of truth that are woven into an erroneous conclusion. There is plenty of evidence that newfangled leveraged and inverse ETFs have had some very surprising outcomes. Levered inverse VIX (volatility index) ETFs got obliterated in the recent spike in volatility. One was recently down 95% in just a few days. This probably spilled over into other areas. One whistleblower also filed a complaint last week claiming the VIX index is getting manipulated by traders reporting bogus stock option quotes that don’t get executed at that price, in order the skew perceptions of risk and the price of volatility. These forces seem unrelated to ETFs, but may have contributed to the near death experience of the VIX double inverse ETF.

But levered inverse ETFs are generally structured as futures funds. Any reasonable person would expect some danger. They generally bet against a particular index with 2x or 3x leverage. But if you’re an over-confident novice who’s been shopping for ETFs by reading the performance column in the newspaper, you might have blindly bought the levered inverse VIX ETF because of a multi-year 40%+ annual rate of return. Chasing performance blindly can periodically blow up in one’s face.

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This will surely give fodder to those professional investors who are victims of the ETF business which has been spitting in their punch bowl. I am highly confident you will soon see numerous articles sprout up claiming that ETFs are to blame for market volatility. Well yes…and no. The levered inverse VIX ETF did trade billions of dollars of short futures to accommodate inflows seeking the “easy money” to be made from the low volatility we experienced for years…until last week. It worked great until it suddenly didn’t. Those trades and that repricing caused rapid-fire realignments at or near the market close, which in turn created other imbalances in the market for other securities, often the next day. This can culminate in a vicious feedback loop, and likely did. I can hear John Cleese now claiming in Monty Python, “She’s a witch! She turned me into a Newt, but I got better!” Let’s be slow in indicting the culprit of market anxiety.

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I have no problem with levered or inverse ETFs. Used properly, they can be a great tool. As a matter of fact, we used them as a tactical hedge in late 2007 to 2008, when we bought 2x Inverse China, 2x Inverse Financials, and 2x Inverse Emerging Markets. Those positions were bought in what is now the Segment ETF-only strategy. This hedge led to an allocation that cut our market risk almost in half right before the S&P 500 lost half of its value. Some of our tiny positions were sold for 400% gains; very timely in a down market. Now we surely lost money overall, but this drastically reduced our exposure at a very important time, and maybe we’ll never be so lucky again. These vehicles do have very quirky construction, and have time value decay and contango cost (futures higher than spot price) from expiring futures and options. They also recalculate themselves daily, which means a straight line underlying market price move can create a parabolic ETF price move. This can mean you correctly predict the underlying price movement but still lose money in the leverage and reconstitution daily.

Suffice it to say that ETFs come in a range of structures, from highly speculative to downright mundane, so let’s not throw the baby out with the bathwater. Speculative structures of any kind can also serve as a great reminder of what not to do. These are not intended as an investment; nor are they built in a way to be properly understood by a novice investor. The levered ones are a trading vehicle for short term visits to produce a briefly desired outcome as a speculation or a hedge. Do-it-yourself buyers should steer clear. And don’t let the overpaid mutual fund industry blame cheap ETFs overall based on the quirkiness of the rare oddball levered ones. As the fingers get pointed, I’m hoping you can smell the sour grapes, and hopefully take that with a grain of salt and some forewarning here.

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