The Good ETF (Kind Of)

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The Good ETF (Kind Of)

The Good ETF, Part 2 (sort of) by David Merkel, CFA of Aleph Blog

About 4.5 years ago, I wrote a short piece called The Good ETF.  I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

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Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures.  I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article: How a 56-Year-Old Engineer’s $45,000 Loss Spurred SEC Probe.  Quoting from the beginning of the article:

Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG (CSGN) note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”

No, you don’t have to trust people blindly.  Reagan said, “Trust, but verify.”  Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets.  In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print.  You need to read the fine print.  Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed.  Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”

[snip]

The offering documents for the VelocityShares Daily 2x VIX (VIX) Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.

“Engineers — we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”

If you are investing, you need to read prospectuses.  No ifs, ands, or buts.  I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish.  Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought.  I read every prospectus for every security that I buy if it is unusual.  I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education.  I am a fan of math and science.  But truly, I want both.  We homeschool, and our eight kids are “all arounds.”  They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning.  Truly bright people are good with both math and language.  Final quotation from the article:

“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote.  Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs].  That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs offered a more investor-driven and fluid system for share creation. We believe the system for share creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we recommend that ETN issuers reformulate the share creation system related to their securities. Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a minimum, the share creation process should be initiated by investors, rather than by the ETN issuers themselves, as we believe profit-motivated investors will be more diligent and responsive in creating ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity.  To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt.  In most cases, that doesn’t work.

So I come back to where I started.  Be skeptical of complexity in exchange traded products.  Avoid complexity.  Complexity works in favor of the one offering the deal, not the one accepting the deal.  I have only bought one structured note in my life, and that was one that I was allowed to structure.  As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing.  Do due diligence in all investing, and more when the investments are complex.  I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term.  You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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