ETF Alchemy and Other Evils

FT Alphaville had a couple of posts yesterday following up on a report about ETFs from the Financial Stability Board. The second post was mostly about iShares' response to the report. Among other things addressed were issues involving ETFs with swaps (and presumably other derivatives) and the extent to which securities lending plays a role in the evolution of the product.

An important macro point that pertains to all investment products, including individual issues, is that there will always be products that for one reason or another will be unsuitable for you but unsuitable for you does not mean unsuitable for someone else. Matt Hougan was on CNBC yesterday talking about inverse ETFs and to a lesser extent levered ETFs and he was asked whether these funds are better suited to professionals as opposed to individuals. He did say professionals but I would say the better answer is that these are more suitable for people able to spend a lot of time on the task at hand which does not have to be limited to professionals and certainly there would be plenty of professionals who should avoid inverse and levered funds.

As a possible rule of thumb for ETFs, the more moving parts under the hood the more time the fund requires. This does not necessarily work for ETNs as there is nothing under the hood but a promise which means understanding at some level the dynamics of the company issuing the debt.

Anyone constructing a portfolio needs to use products they can understand which should be an obvious statement however just because there is a product that you or I may not understand well enough to use doesn't make it a bad product. It could be a bad product but our lack of understanding of a product does not make it bad for someone else. The multitude of ETPs tied to the VIX index are very popular vehicles that some participants have success with. However the dynamics that make them tick are very complicated and not something I want to devote client money toward trying to understand. Unfortunately I am certain there are people trading these funds without a real good understanding of them but that will always be the case with complex funds.

The framing of these conversations is usually incorrect. The conversation should really be about the end user's ability to sort out whether a product is suitable or not and whether they understand the product. The price performance of a levered fund will depend on the pattern of up and down days in the future because of the daily reset needed to achieve the stated objective which is usually a daily result. Over the next six months some double short fund might "do what it is supposed to" or it may not but this is dependent on information that is not knowable. Simple as that. If you can live with that uncertainty then you would be better suited for one of these funds.

Going a little deeper the double short funds (and double long funds and single short funds) use derivatives to deliver the effect. Rarely, very rarely, those markets will face events like in 2008 where there are serious counter-party risks or other near term threats that impede the function of these funds and it could be difficult to be out in front of something like this. It won't happen very often, maybe never again, but if you can't have that sort of uncertainty then these funds are not for you.

Taking it to a different level, you might recall FactorShares recently came out with a suite of funds offering exposure to various spreads like SPX and gold, SPX and oil and and a couple of others all levered to 2X. For some people these might be just what the doctor ordered (although there is no real volume on these) but for anyone paying even a little bit of attention it should be easy to realize buying these requires understanding intermarket dynamics and being able to aggressively mind the store due to the leverage. I am not saying understanding the dynamics is easy but realizing that this is what these are about is. Ruling out funds like this for your portfolio shouldn't take more than a few minutes of work.

It is also important to understand the potential adversarial relationship with the ETF provider. A fund company issues a fund that it believes there is demand for. The fund company hopes to profit off of this demand. This is not necessarily bad unless you don't realize it. It is just as true that the way a fund company helps demand is by building funds that function well with as few surprises as possible. In late 2008 and during the flash crash there were a lot of ETFs that had to endure surprises of varying types. 2008 was about markets ceasing up as the world had to figure a few things out and the flash crash was a temporary malfunction. Both events might be looked at by history as being bad but people who kept their cool were not hurt (except for perhaps the Bear Stearns ETN which I think had symbol YYY). Keeping your cool was as simple as knowing the product well enough to realize that a basket of stocks with a $50 IIV at 2:15 could not be worth $0.01 at 2:40.

When a fund provider creates a very narrow fund there is often rhetorical commentary like does the world need a smart phone ETF or an aluminum ETF? It is obvious that there will be many more very narrow niche ETFs to come. It is not crazy that an investor might do some research and come up with Motorola Mobility (MMI) as a solution for the smart phone theme and come up with Alumina (AWC) to target an upturn in the economic cycle. I would think that the process for coming up with those two names would include, in some order, learning about the industry and then the individual stocks. How much time would this take? That is a different answer for each of us but obviously not every participant has the time/inclination to learn both the industry and the stock. The burden of work to learn the ETF is probably less than with an individual stock and so this is how ETFs can democratize portfolio construction.

All funds (well, there are a couple of exceptions) have their pluses and minuses and it is incumbent on the end user to really take the time to understand what they are buying, in addition to the fundamentals of what they are buying, before they buy it and with funds that simply track baskets of stocks it doesn't have to be an impossible task.