With ETFs, Innovation Breeds More Risk
If you are truly convinced that the price of crude oil will rise today and U.S. stocks will fall, FactorShares 2X: Oil Bull/S&P500 Bear is for you. The exchange-traded fund uses futures to deliver double the daily change in the difference between the price of oil and stocks. “That product represents the result of a lot of feedback from institutional investors, including hedge fund managers, about how an ETF could assist them in implementing their investment strategies,” says Stuart Rosenthal, chief executive officer of New York-based Factor Advisors, which offers the fund.
Exchange-traded funds have grown increasingly obscure and resistant to explanation as they cater to the needs of hedge funds and other sophisticated investors. Because access to those ETFs isn’t restricted to professionals, they are also available to individual investors who may misunderstand and misuse them with devastating consequences. “If you make it available to the masses, watch out, because the masses might buy them,” says Paul Justice, an analyst with fund researcher Morningstar.
Today, anyone in the U.S. can invest in more than 1,400 exchange-traded products (ETPs)—the catchall term for funds, trusts, and notes. Among the choices are trusts that track groups of hedge funds and the Swedish krona; and a note from the Royal Bank of Scotland that, according to the product’s description, “utilizes a systematic trend-following strategy to provide exposure to either the BNY Mellon China Select ADR Total Return Index or the yield on a hypothetical notional investment in three-month U.S. Treasury bills.”
ETFs didn’t start out as specialized products. “The guiding mission of the first ETF was cheaper, better, faster exposure for investors to swaths of the stock market,” says Steven Bloom, an assistant professor of economics at the U.S. Military Academy at West Point who, along with the late Nate Most, developed the SPDR S&P 500 Trust, known as the Spider, which began trading almost 20 years ago. It was a basic index fund that tracked the S&P 500. Unlike a mutual fund, it could be bought and sold continuously during the trading day. It charged the same management fee as Vanguard’s Standard & Poor’s 500-stock index fund, and was structured in a way that created smaller tax bills for investors. Over the next several years, providers created ETFs that aimed at narrower targets. Funds opened to track single sectors and individual countries and to focus on value or growth stocks and companies of various sizes. The first fixed-income ETF in the U.S. arrived in July 2002, and the first commodity-based product, a gold trust, in November 2004.
While they became more specialized, the investments still tended to be pegged to well-established market benchmarks, such as the Russell 2000 or Nasdaq 100, and to hold most or all of the stocks in those indexes. Most were also registered under the Investment Company Act of 1940, which provides investors clear protections related to safeguarding assets and mandates certain disclosures.
More profound change—and new terminology—came in 2006 with the introduction of three exchange-traded investments based on derivatives. The first was a commodity tracker from Deutsche Bank that used futures contracts, making it possible to invest in materials difficult to receive and store, such as oil and wheat. In June of that year, ProShare Advisors opened a series of eight leveraged and inverse ETFs, using swap contracts to amplify or bet against the daily movement of an equity index.
The first exchange-traded note arrived in August 2006. Linked to a mixed commodities index, it held no product or derivative contracts; it was backed solely by the creditworthiness of its provider, Barclays. Derivative-based commodity ETFs, leveraged and inverse ETFs, and ETNs in the U.S. hold a combined $58.8 billion of investors’ money. In all, exchange-traded products in the U.S. held $1.2 trillion in assets at the end of April, according to BlackRock.
For institutions, the innovations represent an easy way to pursue familiar investment strategies. But the funds also give individual investors access to a dramatically expanded array of potentially risky bets. When Credit Suisse announced on Feb. 21 it had stopped creating shares in its VelocityShares Daily 2x VIX Short-Term ETN, experienced players knew the lack of new supply amid rising demand meant the ETN’s price might start rising more than the index it was designed to track. When a premium appeared in the price, they stayed away.
Less knowledgeable retail investors continued to buy even as the premium over the underlying index rose to 89 percent. When Credit Suisse announced on March 22 that it would soon begin issuing shares again, the premium collapsed, and the price plunged 50 percent in two days. The Financial Industry Regulatory Authority is reviewing the episode. A spokesman for Credit Suisse says the bank is cooperating with regulators. In May, Finra fined four banks for selling leveraged and inverse ETFs to clients who didn’t understand them and lost money.
Partly in response to the growing complexity, the Securities and Exchange Commission in 2009 stopped approving new funds that made significant use of derivatives. The agency has also hired staffers with expertise in exchange-traded products. The SEC has begun a review of ETPs, examining their contribution to equity-market volatility in 2010 and the 8.6 percent intraday plunge in the S&P 500 on May 6, 2010, known as the flash crash.
BlackRock, the biggest provider of ETPs in the U.S. and globally, has proposed that regulators seek clearer labeling and risk disclosures to aid individual investors. David Nadig, director of research at ETF research firm IndexUniverse, has argued that regulators should go further, installing “gates” in front of some ETPs to prevent unqualified investors from buying them. That could require brokerages to approve investors one by one for products that make heavy use of derivatives. Michael Sapir, CEO of ProShare Advisors, believes explicit restrictions would be unfair to providers if they singled out ETFs when some mutual funds and investment professionals use derivatives as well. Regulators, he says, should continue to demand “full and fair disclosure” from providers without restricting access to ETPs. “Do you want to turn the clock back 30 years?” he says.
Bloom, the economist who helped invent the first U.S. ETF, says an approach based on “buyer beware” may not be good enough, especially when prospectuses and other disclosure documents are difficult even for sophisticated investors to understand. “More important even than their responsibility for any one product, regulators must ensure that public trust is maintained,” he says. “Capital markets are predicated on trust, and when public trust dwindles it can cast a cloud over the entire capital markets.”