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ETF

More derivative witch hunts

November 17, 2009 in Finance

Going through the FT’s original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn’t going to be as easy to understand as SPY. But that doesn’t mean it’s “out to get” investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS? Now those were truly frightening derivatives – leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC’s are nothing compared to that. In fact, they’re no more terrifyingly complex – and much less manipulable – than the commodity ETFs Alphaville covers so frequently. Yes, they’re the first currency ETFs (sorry, FT insists that it’s wrong to confuse these for ETFs, even though they don’t say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don’t even know where to start with this one. Maybe the author wrote this because the word “collateral” appears frequently in the prospectus. I wonder if it’s the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We’re talking about total return indices on the deepest, most liquid market in the world – not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it’s not exactly a free trade. One of two things must be true:

MS doesn’t want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they “steal” the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they “steal” the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there’s really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: “AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie Mae and any equity listed on ’specified indices’ anywhere in the world” (and I’m going to hazard that adding “anywhere in the world” is yet more bait, since the “specified indices” are major ones in developed economies). Let’s call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers. And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends – they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the “potentially illiquid” line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid – they represent claims on FX derivatives! There’s no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here’s a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There’s a third option, which is to buy SPY – effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it’s the swap.) Yes, a TRS is a derivative – but it’s not evil by that virtue. It’s exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let’s not get all suspicious of these crazy methods for replicating payoffs.

I’m not going to pretend that these ETCs are vanilla securities. They carry risks – perhaps large ones – and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven’t read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT’s attitude rather than the securities themselves. I can’t endorse any sort of derivative witch hunt of this sort – its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it’s hardly appropriate here.

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Only in America

September 3, 2009 in Finance

The law firms of Pearson, Simon, Warshaw & Penny, LLP and Tydings & Rosenberg, LLP have just announced a class-action lawsuit against ProShares Trust on behalf of everyone who has ever owned shares of SKF, the double-short financials leveraged ETF. Key quote from the press release:

For example, in a six week period from September 15, 2008 through October 31, 2008, the DJFI declined by over 17%. Despite a reasonable expectation based upon Defendants’ disclosures that SKF would rise by up to 34% during this period, SKF actually fell by nearly 6%.

“Reasonable expectation?” I have written not once but twice on why leveraged ETFs will fail to track their underliers over time by explicit design. There is no mystery here; there is no reason for the tracking to persist over any period longer than one day, much less six weeks! Not only does ProShares makes that point quite clear in their prospecti, but it should be plainly obvious to anyone who stops to think about how the ETFs work. Only in America can you completely misunderstand a product and still sue someone for failing to meet your expectations.

Then again, perhaps these law firms stand to collect fees no matter whether they win or lose this baseless lawsuit. In that case, the investors who sign on will have been duped twice.

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How to lose your money without really trying

April 27, 2009 in Finance, Math, Risk

I am very interested in the topic of leveraged ETFs (I wrote on it just last week) – and a key point I always come back to is that levered ETFs exhibit a negative drift over time. I illustrated this by plotting the inverse double levered financials ETF (SKF) vs its underlying index, the IYF. The IYF was down 66% and the SKF, which by design rises when the IYF falls, was down 16%. That should be warning enough that leveraged ETFs do not move as common sense might expect.

One can go through the math and actually prove that

$r_L = (r_U)^x\exp\left(\frac{(x-x^2)\sigma^2N}{2}\right)$

where $r_L$ and $r_U$ are the respective ETF and underlier N-day returns, $x$ is the ETF leverage ratio and $\sigma$ is the N-day realized volatility. Critically, the term in the exponent must be less than one, which accounts for the negative drift. The negative drift term grows as either leverage or volatility increase, so levered ETFs are actually short volatility! As the authors of the linked piece put it:

The gross return of a leveraged or inverse ETF over a finite time period can be shown algebraically to be simply the gross return of the ETF’s underlying index over the same period raised to the power of the leveraged multiple of the ETF, multiplied by a scalar that is less than one.

If not for the negative drift, a fantastic trade idea would be to buy both a highly-levered long and short ETF on the same underlier, taking full advantage of the non-recourse leverage: wait for the underlier to move far from it’s current position, at which point one of the ETFs will be at zero but the other will have more than doubled, netting a profit. Unfortunately over time and without careful management such a position is a deathwish.

But C.S. Jefferson at Seeking Alpha has actually recommended that investors do just that – with the long and short triple-levered financial ETFs! He has even put on the trade himself! His reasoning shows that he has the entire concept backwards (in particular with regard to volatility):

In options trading, [the trade] would be somewhat reminiscent of trading a long “strangle” or “straddle” position by buying volatility. The fundamental difference is that in theory, unlike options facing expiration dates, you are not exposed to timing it to the moment the market makes its move…

The real potential outcome and goal is that the multiplier effect should push either side of the trade much higher with returns outpacing the downside losses. Because of these current price levels, your maximum loss on either side of the trade should be capped at approximately eight dollars or less per share if one approached zero, while the inverse correlation on the other side of the trade has unlimited upside.

The only way this trade can be profitable is in a sustained trend, where the “strangle” delta component outweighs the short volatility piece. Think of a simple example – the underlier moves up 10% and then down 10%. Both the double levered long and short start at 100 and end at 96, a net loss of 4%. Now instead take a trend like two consecutive days +10% and you wind up making 4%. But even trends can be treacherous: follow that +10% trend with two days of -10% and you lose money all through the reversal. The only circumstances under which this strategy works is if a trend starts immediately after putting it on, or if a later trend is sustained for a considerably long time.

Amazingly, Jefferson even recognizes the fact that this trade would have lost massive amounts of money in the past and views it as a “dislocation” or opportunity (I’m taking these two paragraphs out of order; emphasis is mine):

It’s bizarre, but if you had tried to apply this same strategy upon inception of the newly devised ETFs in the fall of last year, the outcome would have been brutal had you held and you would have taken a major beating on both ends of the trade. Clearly, the ineffectiveness of some of these similarly leveraged and inverse structured ETFs do not perform as promised. In fact, in hindsight, the ultimate trade on some of these newly issued ETFs may have been to short both sides of the trade from the get go. But without the luxury of hindsight, I would never have made that trade anyway.

You would have to assume that the design of both FAS and FAZ was to provide divergent instruments, both moving in opposite directions. However, due to extreme volatility and price dislocations in the markets since the fall of 2008, this financial crisis has presented opportunities that were unintentional. These ETFs were not designed to trade in tandem on a parallel course and trajectory rapidly approaching zero as they have recently. Interestingly enough, we now have a crisscross intersection of lines if you graph both positions to suggest extreme price dislocation.

In fact, if he had read the prospectus he would see that these ETFs perform exactly as promised and exactly as they were designed. Woe be unto the trader who trades a product he does not understand. Aside, it’s unclear why he is obsessed with the fact that the ETFs traded at the same dollar price, causing their price graphs to intersect. Clearly he subscribes to the school of investors that believe stock splits matter. Let’s be clear – the dollar value of a stock’s price is irrelevant; that’s doubly true for ETFs whose prices depend solely on percentage moves of their underliers.

The obvious retort to all this is to short both ETFs. Plainly, if what I’m saying is true, both have strong downward trajectories. And the answer, as you might expect, is maybe. A double-short strategy would most likely play out over time (and certainly has in the past) but would be subject to extreme mark-to-market swings as short-term trends grow the value of one side of your short but not the other (ironically, the very move Seeking Alpha is looking to capture in the long run). The resulting margin calls could be disasterous; look at a backtest of Seeking Alpha’s trade to see why.

As to C.S. Jefferson’s other suggestion – “Back in early March, I opted to enter a trade of writing naked equity puts which initiated my first entry on the FAS ETF” – I can’t even express the horror I feel from a risk management perspective. However, because this trade worked out for him in March (as did every short), he is looking for an opportunity to put it on again.

Update 10/27: The joke is on us! In April I wrote, “The only way this trade can be profitable is in a sustained trend,” and 6 months later the unprecedented equity rally resulted in this trade being very profitable indeed. Please do not make the mistake of confusing return for an absence of risk, however.

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The math (and myths) of leveraged ETFs

April 20, 2009 in Finance, Math

Leveraged ETFs are vehicles which provide non-recourse leverage on various sectors or strategies. For example, every day the double-inverse financials SKF returns roughly -2 times the daily return of the DJ Financials index.

These products are a favorite of mine not simply in a speculative framework, but in a quantitative one. Many people make the mistake (and it can be a serious one) of assuming that a double-levered ETF should return twice as much as its underlying index over a given holding period. That’s incorrect – the ETF’s only return their stated multiple for one day. After that, the ETF has to relever itself in order to maintain it’s mission. This is because the ETFs typically acquire leverage through the use of total return swaps (TRS). A total return swap is a swap in which the two counterparties agree to exchange the exact same cashflows as if they had traded a security. For example, counterparties A and B enter into a TRS on some stock Z, struck at $100. A pays B $1 for every dollar Z goes above $100, and vice versa for every dollar under. It is exactly the same as if B bought Z from A, except that no capital had to be put up (thus, it is a levered trade). The important thing to note is that each unit of a TRS provides a dollar return, not a percent return. Owning twice as much TRS means you make $2 for every $1 the stock goes up. Therefore, the ETF must rebalance to maintain it’s constant multiplicative exposure.

Here’s an example. The underlying index X starts at $100. My double levered ETF E also starts at 100 and because it is double levered, it must own twice as much TRS as it would hold stock in the underlier. Let’s say E has $100 in assets, so it owns 200 units of TRS. On the first day, X increases 10% to 110 as each share gains $1. E increases 20% to $120, as expected, since each TRS gains $1 as well. The following day, X increases another 10% to 121 (each share gains $1.10), and we expect E to grow 20% to 144 ($24 gain). However, E only owns 200 units of TRS, which means it will earn only $22 dollars as each TRS gains $1.10. In order to realize a $24 gain and return its target 20%, E would have to purchase 20 more TRS at the end of the previous trading day – and that act is the relevering.

It is especially interesting to note that E must re-lever in the direction the underlier moved regardless of whether the ETF is long or short. Above, the underlier kept increasing in value – and E had to purchase more and more to maintain its leverage ratio. Conversely, had the underlier fallen, E would have been selling into the decline. As levered ETFs attract more and more assets, this end-of-day relevering can have market impact, enhances gains and exaggerating losses.

The second key fact about levered ETFs is that they exhibit a strong downward drift, moreso as the leverage increases. This is why if you plot an index against it’s triple-levered inverse ETF, both can decline in value over time despite the ETF’s mission of returning “opposite” results. To see why, consider what happens when an index moves up 10% and then down 10%: it doesn’t go back to where it started, it actually loses 1% (order of the moves does not matter, either). It goes from 100 to 110 to 99, or if you prefer from 100 to 90 to 99. Either way, 10% up and 10% down is not an even trade.

Now lever it 3x. Before, you lost 1%. Now, shouldn’t you lose 3%? 10% up and 10% down become 30% up and 30% down, or 100 to 130 to 91, for a loss of 9%. You didn’t lose 3 times as much, you lost 3-squared times as much. And we can easily extend this to a case where the underlier is up but the ETF is down: 10% up and 8% down, which results in a 1.2% gain for the underlier, but a 1.2% loss for the ETF. More complicated examples are easy to construct, and here is a real-world one of the SKF vs its underlier, the DJ Financials index. The index is off 66%, while the double inverse ETF is off 16%:

levered-etfs

And if this discussion hasn’t been fascinating enough, Barclays recently put out a recearch piece delving much further into the math behind these elusive securities and exploring the impact of the relevering process.

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