ETFs - you were warned

The losses of $2bn incurred by an allegedly rogue trader on the Delta One desk at UBS have again raised the subject of the (lack of) risk controls by banks dealing in opaque instruments, the need to separate investment and retail banking and the risks inherent in ETFs.

I have written over the past year about the unappreciated risks in ETFs and it is probably time to bring these thoughts up to date.

ETFs are regarded by many investors as the same as index funds. They clearly are not:

1. Some ETFs do not hold physical assets of the sort they seek to track. They are "synthetic" and hold derivatives. This gives rise to a counterparty risk, and as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives. What if (when?) such ETF trades cause such a mammoth loss in a counterparty which does not have sufficient capital to bear the loss and pay out under the derivative contract? Answer-the ETF will fail.

2. ETFs do NOT always match the underlying in the way people expect. Because of daily rebalancing and compounding, you can own a leveraged long ETF and lose money over period when the market goes up but during which there are some sharp falls. Equally, you can own an inverse ETF (which provides a short exposure) during a period when the market goes down but there are some sharp rallies and lose money. This actually occurred with some inverse ETFs in 2008. I would strongly suggest that people would not expect to be leveraged long and lose money if the market goes up or short and lose it when it goes down.

3. Because you can exchange trade these funds, they are used by hedge funds and banks to take positions and they can short them. Because they can apparently rely upon creating the units to deliver on their short, there are examples of short interest in ETFs being up to 1000% short i.e. some market participant(s) are short 10 times the amount of the ETF. If the ETF is in an illiquid sector, can you really rely upon creating the units as you may not be able to buy (or sell) the underlying assets in a sector with limited liquidity? The danger of allowing short sales which are a multiple of the value of a fund in an area where it may not be possible to close the trades by buying back the stocks are clear, but amazingly, during the debate in which I have been engaged by various cheer leaders for ETFs, they have claimed that there is no such risk in shorting ETFs. They clearly do not understand the product they are peddling, and if they can't what chance has the retail investor got?

4. Although ETFs are billed as low cost they are also the most profitable asset management product for a number of providers. How can this apparent contradiction be so? The answer is that the charge for managing the ETF is only one part of he cost. There are also the hidden costs in the synthetic and derivative trades which the provider undertakes for the ETF.

As a result of all this I have long thought and written that there is a certainty that ETFs are being mis-sold to the retail market and that the risks that are being incurred in running, constructing, trading and holding them are not sufficiently understood. After the UBS incident I think this should be regarded as indisputable.

10 January 2011: Do you know what’s in your ETF

24 May 2011: ETFs – worse than I thought

Comments

[Peter Smart]

Terri,

All very interesting but how can we identify which ETFs are "synthetic" and which are not. Trustnet does not appear to have any way to describe if an ETF holds physical assets or is "synthetic". Can you point us in the right direction?

[James Hunter-Jones]

I totally agree with TS on the etf front - they are an accident waiting to happen for many investors' portfolios. Can I ask whether anyone actually believes that they may have been linked to the UBS traders $2bn loss or is it purely incidental that he was trading ETFs, could he have been trading any other financial instrument?

[Ken Charman]

I am 55 and I am getting fed up with the financial services sector. I think it might be time to take a 20 year hit of poverty and clean it up. The banks are a bigger and even more out of whack threat to the rest of society and the economy than the unions were in the 1970s.

Recently, I played a game with a friend who (like me) has led a successful career in the software industry and we both had to write down a single event where it (the economy and society) all went wrong in our lifetimes. Without collusion we agreed. It was Big Bang in the City. From this point wages spiralled in London and lost any connection with real world value added. Even more dangerously it moved an at risk community over the cliff to institutional as well as individual amorality (anything you do is ok as long as you are making money and you aren't caught).

Both attitudes escaped from the pit and poisoned everything else - from Fat Cat CEOs to the absurd over payment of GPs. The salary differentials system in the UK now stands like a house of cards where everyone justifies their earnings in relation to each other rather than what they contribute.

Anyway..!!!

I enjoy the blog. I rate Accounting For Growth as my equal top business book. The other is Bent Flybbjergs "Mega Projects" which exposes the systematic misrepresentation behind public infrastructure projects. As well as working in business I am a research fellow at KCL War Studies and share the views on Sir Keith Park that are recorded on this site. ( I was a donor to the memorial ).

Keep up the good work. Spot on.

[Geoffrey Smith]

Dear Terry,

Hard-hitting stuff. I would like to use some of it for a story I'm doing for Dow Jones & WSJ Online on what this means for the ETF industry, but first I want to make sure - how are you so certain that the case is related to ETFs? Is it really impossible that the trades that generated the losses were unrelated to them? (Neither the bank nor the police are confirming anything so far)

Kind regards,
Geoffrey Smith,
Dow Jones Newswires

[Terry Smith]

To Geoffrey Smith

I'm not sure that the cause of the UBS's losses was trading in ETFs or some part of their component structure. We just know that the trader involved traded ETFs amongst other instruments. However, whatever the direct cause of the UBS losses, I still stand by all of the criticisms which I have made of the dangers of ETFs-the UBS incident is at this stage is just useful to highlight them.

[Alan Butterworth]

Perhaps the term ETF should be restricted to funds which directly hold the shares or other assets which the fund is supposed to represent. The others could be required to designate themselves as ETDs (exchange traded derivatives.

[Dermot Driscoll]

Terry
I am a private investor holding a diversified range of iShares ETFs, mainly in large indecies (S&P 500, FTSE 350, Asia Pacific ex Japan etc.) All are replicated funds but while you rightly warn on synthetic ETFs you neither include replicated funds specifically OR say they are safe.
Please can you comment on the risks of replicated funds.

[Steve Ritter]

To Peter Smart:

If you read the rules they play by (SPDRs here: https://www.spdrs.com/library-content/public/SPDR%20Series%20Trust%20SAI.pdf ) you will see--check pages 36 and 87 for salient points--that any SPDR ETF can, in theory, contain money market instruments in combination with leveraged derivatives to achieve their stated investment goal. They can change this on a day-to-day basis and not inform investors until the market opens the next morning. The indices themselves have their own restrictions but ETF sponsors and custodians can essentially decide what rules apply to them and when.

To Geoffery Smith:

In the world of delta one, in theory, it is quite hard to lose a lot of money. Every trade should be easy to hedge using public markets. ETFs distort apparent liquidity of underlying instruments and the amount of cash involved in their financing relative to their implied market cap (shares outstanding x (1 + short interest)) outstrips index futures and cash equities by leaps and bounds. A misjudgment of liquidity in both cash trades and in ETF lending markets could have created a significant hole in the books in a way that a basket-hedged index swap would have had a hard time doing.

As Terry says, nobody knows for certain where the losses came from, only that ETFs are Delta One's major area of massive, misunderstood risks and this is a great chance to revisit the questionable arena in which they operate.

[Bert]

Hi Terry
Partly I can follow your criticism but not everywhere. Regarding the counterparty risk I think the protection is good.
Let's take the DB xtrackers as an example. They give you a daily update on the swap exposure and of the value of the collaterals which has to be more than the NAV. Yes in times of a crisis the value of the collateral might fall below the NAV of the ETF but for a standard index tracker its very likely that the value of the index will also fall and the collateral is giving you a fairly good protection here. I think in this sense it is a bit unfair to say that you are having a bit counterparty risk exposure.

[Esteban]

Terry, I applaud your crusade on EFTs, I also recall "Accounting for Growth" in your UBS days - right in both cases - however, the current UBS UT risk and control failures are presumably not directly related to EFTs per se (i.e. by type of trade). My guess is they loss will be from position believed to be but not "hedged", being with false hedge deals for which inward counterparty confirmations controls and principles were compromised. For all the industry talk about KRIs presumably there was no data mining monitoring of abnormal statistics such as of trade reversals, cancellations. But with such staggering incompetence applying here, who knows ?
There are doubtless some common factors applying to this UT and EFTs in the general, such as overpaid incompetents employed in risk management who know nothing about operations, and a regulatory body that is lamentably unfit for purpose (RIP). After the Soc Gen case surely the first act would be to reverse engineer the lessons learned to stress test the policy procedures and controls - the dealer gets arrested and the risk and control people carry on ? "a right carry on" indeed. To be clear, (cumulative) UT can be stopped, but management incompetence we seem to be stuck with.

[Paul]

To Peter Smart:

I think the safest way to check is to look at the particulars for each specific ETF you're interested in.

For example, the ETFS Lead product at http://www.etfsecurities.com/csl/classic/etfs_Lead.asp says "The commodity exposure is obtained from experienced third parties (Commodity Contract Counterparties) and whose obligations are secured with Eligible Collateral covering 100% of the outstanding value." In contrast their ETFS Physical Lead at http://www.etfsecurities.com/iml/etfs_physical_industrial_lead.asp says "Physical Industrial Metal securities are backed by physical metal stored at London Metal Exchange (LME) Warehouses, the ownership of which is evidenced by LME Warrants (LME regulated warehouse receipts) or warehouse receipts held by the Issuer."

[suzanne]

UBS went through audits. their accountants/auditors didn't assess the risk well?

will it happen again? i think so. if this didn't show up on financials, what other "trades" don't also show up on UBS or other bank and brokers' financials?

the brokers and banks must have their positions audited, the sooner the better. volatility will expose more and more of these positions.

i predict we will see:
governments and banks vs. brokers and shortsellers.
many brokers are broke, have borrowed and sold their customers' stock. margins are calculated using their customers' stock.

this is inevitable, and i think this scenario will play itself out in the near future.
everyone had better have an emergency plan.

[Steve F]

We discussed today how is it that when I make a small but unusual transaction on my credit card the bank calls me to check. This is because of risk management software that is designed to detect fraudulent transactions out of millions of transactions daily. Yet a trader from perhaps 200 other traders can apparently trade 2.3Bn+ dollars fraudulently in relatively few transactions without any bells ringing at all.

The presumption is that actually the bank wants these traders to take risks and as long as they make money does not want to know how.
I notice that compliance programs including Basel and SOX never seem to cover the basics of

1: does this transaction make money
2: can we collect the money without fear of returning it

Two simple questions that if asked and checked weekly would prevent around 90% of these massive loss situations. Pay commisisons only on collection and see how the business changes.

May I also claim patent rights on those questions before Apple does.

[Terry Smith]

To Peter Smart

If you look at the fact sheet on the ETF providers web page it should tell you whether it is a replicated ETF which holds the physical instruments or a synthetic ETF which uses derivatives.

[Terry Smith]

To Ken Charman

I can only agree. Interesting that you mention Big Bang. In all the comment about banking reform, the adverse effects of the Big Bang "reform" have been totally overlooked. The Big Bang changes were founded on a complete misconception and legitimised insuperable conflicts of interest.

[Terry Smith]

To Dermot Driscoll

Replicated funds are in my view highly preferable to synthetic ETFs but they are still not without significant risks. For example, do you know what the short interest is in your ETF, replicated or synthetic? If it is large,(I have seen up to 1000%) doesn't that mean that the ETF only holds a fraction of the assets required for the outstanding number of units?

[Terry Smith]

To Bert

Why would you voluntarily own an instrument in which you have to concern yourself about counterparty risk and collateral?

[Terry Smith]

Esteban

As a great man once said, always buy a business which can be run by an idiot, because sooner or later they all are. I hope no-one would contend that it is OK to have an idiot running a business in which traders can take positions on a so-called Delta One desk which involve offsetting index futures against ETFs. That's why I don't and won't own any bank shares.

[Phil]

"as we saw with the UBS incident, some interesting risks within the counterparties supplying the basket of derivatives."

Wrong. The UBS incident involved fictitious trades and had nothing to do with the ETF structure.

[Iain]

Authorities on both sides of the Atlantic are muttering their concerns about ETFs, even to the extent that the Serious Fraud Office has highlighted the potential risk to stability involved. A range of market luminaries and other investors have made their concerns clear, but people still seem to be bewitched by the salesmen’s siren call because the wrapper looks nice and the small print appears innocuous and is impenetrable. ETFs are another potentially good idea, that are now being consumed by the financial engineers.

[Westwinds3]

Terry,
An excellent summary of your excellent campaign. My question. Could the ETF creator not be required to state a limit to the number of units they guarantee to create? This figure could be adjusted from time to time if the ETF proved popular, but would surely limit short positions?

[Terry Smith]

To Iain

I agree with you. There are many financial innovations, including securitisation, credit derivatives and ETFs which have merit but which are completely perverted by the financial engineers, invariably with disastrous consequences.