ETF Caution

This is very valuable to my readers who invest/trade in ETF's:


IndexUniverse.com
How Safe Are Your ETFs?
Friday October 10, 1:03 pm ET
By Matthew Hougan

The swirling financial crisis has investors questioning the safety of all types of investments, from bank accounts to CDs, money market funds and more.
Nothing seems safe. Even exchange-traded products.
The failure of the Lehman Opta exchange-traded notes in September awakened many to the credit risks inherent in the ETN structure. Now, the expanding credit crisis has many looking at the fine print of traditional exchange-traded funds, too.
Reviewing Stock ETFs
In general, the money invested in traditional stock exchange-traded funds appears safe from rampaging credit markets. Not safe from market movements, of course, but safe from the kind of credit risks that killed the Lehman ETNs.
As with mutual funds, when you purchase a traditional equity ETF, you purchase a pro rata stake in the holdings of the fund itself. For instance, when you buy the S&P 500 SPDR (AMEX:SPY - News) or the iShares S&P 500 Index Fund (NYSEArca:IVV - News), you are effectively buying a tiny piece of each of the 500 stocks held by those funds. That compares with an ETN, where all you are buying is a debt note from the underwriting bank.
There are risks to ETFs, however.
Many mutual funds and ETFs participate in the share-lending market, where they lend shares of their underlying stocks to investors who want to short a particular company. The short-seller will typically give the fund company cash as collateral, which the fund company then invests in short-term fixed-income instruments to make a little extra money.
This excess return sometimes is paid wholly to the ETF shareholders and sometimes is split between the shareholders and the ETF manager. It tends to vary by fund company, and many complexes refuse to disclose the split publicly.
Recently, failures in short-term commercial paper markets have caused some banks to lose money in their share-lending departments. So far, none of these losses has occurred at ETF providers, but there is some risk of losses on the margins if the credit crunch expands.
There is also a lack of transparency on what the fund companies receive as collateral in share-lending agreements. It is usually cash or short-term Treasuries, but there is no hard-and-fast rule, and very limited disclosure. The risk of a problem is very small, but many have called for increased disclosure of share-lending requirements.
It's worth noting in such an environment that there is a type of equity ETF that avoids this risk:the unit investment trust (UIT). This is a structure employed primarily by the earliest generation of ETFs, such as the aforementioned SPY, the Dow Jones Industrials Diamonds (AMEX:DIA - News) and the MidCap SPDRs (AMEX:MDY - News).
Unlike other ETFs, which are technically open-end funds, UITs are restricted from share lending altogether. They have their drawbacks—they cannot reinvest dividends, and as such, have a small cash drag compared with open-end funds and tend to underperform those funds slightly over the long haul. However, UITs may be the safest equity structures of all at the moment.
In general, the risk from share lending is small, but for the ultracautious, it may be worth considering.
Leveraged & Inverse Funds
The leveraged and inverse ETFs offered by ProShares and Rydex come with different kinds of risk.
The ProShares inverse funds, for instance, have historically relied on swaps to achieve market exposure. Swaps are privately negotiated contracts between two parties. The parties agree to exchange money based on the return of a given index.
For an inverse ETF tied to the S&P 500, for instance, ProShares might agree to give the counterparty cash if the index goes up, and the bank will agree to give ProShares cash if the index goes down. The risk is that these are privately negotiated contracts. If the counterparty in a swap goes bankrupt, the ETF company is exposed.
In fact, we saw this play out in a small way earlier this year when Lehman Brothers went bankrupt. ProShares likely had a few swaps in place with Lehman at the time. The company issued a statement following the bankruptcy saying that its exposure to Lehman was minimal; it also said it would make the ETFs whole if they suffered any losses as a result of Lehman's troubles.
Among other things, such action showed that ProShares monitors its counterparty risk closely, and in this case, agreed to indemnify shareholders. Still, it also revealed that some risk exists in the swaps market.
Note, however, that the size of this risk is limited. This is a commonly misunderstood point.
In a swap contract, the two parties do not exchange the principal of the investment; it is not as if ProShares or Rydex gives the counterparty all of the value of the swap to hold as collateral.
In fact, there is typically little or no cash exchanged at the start of a swap. The risk in a counterparty failure is that the counterparty will fail to pay for the change in the value of the index that occurred after the swap was put in place, not for the core value of the position itself.
As of its last semiannual report, ProShares ETFs had swaps with Bank of America, Credit Suisse and JPMorgan Chase, among others.
The Rydex inverse funds rely on a combination of futures, options, swaps and other instruments to gain exposure to the market.
Futures and options do not carry the same level of counterparty risk as privately negotiated swap contracts, as they are cleared on an exchange, which provides an extra guarantee that the contracts will be honored. Still, the exact mix of components is hard to determine, and there is risk with these funds too.
There is one further risk to the inverse funds.
In September, the Securities and Exchange Commission enacted a ban on short-selling in many stocks. This made it difficult for some of the inverse funds (in particular, the Financials-focused funds) to gain short exposure to the market. That's because the swap counterparty needs a way to hedge its position. If it is unable to short the underlying stocks, it cannot hedge its commitment to deliver inverse returns, and so will refuse to create more swaps.
Following the SEC's ban, both Rydex and ProShares had to suspend creations in their short Financials ETFs. That created a risk that the ETF shares might trade at a premium to their net asset value. After all, if there are a fixed number of shares and a potentially unlimited number of buyers, those buyers can drive the price up above a reasonable level.
Fixed Income Funds
Fixed-income funds operate like traditional equity ETFs, with investors holding a pro-rata share of the underlying markets.
Of course, all fixed-income funds are exposed to the risks of the fixed-income market, including defaults and (recently) illiquidity.
Illiquidity is a real issue for ETFs, as it can cause funds to trade at significant variance with their underlying indexes.
Illiquidity can also mean large spreads for the related ETFs. As long as the credit markets remain illiquid, investors should trade in and out of these funds with extra care.
Precious Metals Funds
The precious metal bullion funds are very safe. These include the SPDR Gold (NYSEArca:GLD - News), iShares Silver Trust (AMEX:SLV - News) and iShares COMEX Gold (AMEX:IAU - News) ETFs.
These funds hold physical precious metals bullion as their sole asset. The metal is stored in a vault with a custodian bank. It is not like a cash deposit where there is deposit risk.
There are circumstances under which these holdings can be lost—terrorist attacks, acts of God, etc.—but they are extraordinary.
The bottom line:These funds are as safe as, well, as safe as gold in a bank vault.
Commodity Futures Funds
Despite their risky reputation, commodity futures funds are relatively safe from a credit and counterparty perspective.
While each commodity futures trade has a specific counterparty, trades are cleared through major exchanges like the NYMEX or CME, which act to monitor and guarantee counterparty transactions. A default by a major exchange is conceivable, but has not happened in recent memory.
Currency Funds
The majority of currency ETFs hold physical currency as their sole asset. For all intents and purposes, these are essentially bank accounts, and come with the same rights and risks as other bank accounts.
In many cases, these accounts are held in London, and have limited protection under the deposit insurance programs in England and are not insured by the FDIC. If the deposit bank for one of these funds fails, investors could lose money. JPMorgan is the deposit bank for the most popular line of currency ETFs, the CurrencyShares from Rydex.
WisdomTree and others have recently launched currency funds that hold time deposits and short-term commercial paper instead of actual physical currency. These funds do not share the deposit-level risks of the deposit funds, but, of course, the commercial paper market has its own risks as well.
Exchange-Traded Notes
Exchange-traded notes are debt notes. As a noteholder, you are fully exposed to the credit of the underwriting bank.