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Posted by on May 29, 2014 in CEO Corner

Leveraged ETFs Won’t Blow-Up the Entire Industry

Leveraged ETFs Won’t Blow-Up the Entire Industry

By Noah Hamman

I don’t think Larry Fink is right about leveraged and inverse ETFs with his remarks yesterday.  And for the record, AdvisorShares was recently described as a firm proposing to offer an ETF “to double down on junk rated loans” which is absolutely inaccurate.

Here are some thoughts to give a proper framework to understand leveraged and inverse ETFs.

First, I should start off by saying registered investment company funds are one of the most heavily regulated, shareholder friendly fund structures, and which 99% of assets in ETFs are offered in that structure type.  Also, investors have benefited from the daily transparency of ETFs by being able to quickly and easily know exactly what their funds are holding—bonds, domestic equities, international equities, international bonds, futures, options, swaps—no matter what it is, there is no reason for investors to be surprised about what is being held in their ETFs.

If I were to suggest a particular ETF would have a higher risk, it might be a country ETF.  I am favorably disposed to country funds and feel the structure is perfectly safe but occasionally there are disruptions in some foreign markets – whether it be a coup in Thailand or the closure of the Egyptian stock exchange for weeks during the country’s 2011 revolution. There was of course a significant amount of concern over when the Egyptian market would reopen, as well as uncertainty over the true value of stocks held in the Egypt ETFs.  Consequently, the ability to create or redeem new shares was suspended – although not the intraday trading, only the transactions at the end of the day that go directly to the fund at NAV.

So now think about Russia.  The U.S. government is freezing assets, putting on sanctions, and who knows what the Russian government might do with their own stock market and what that means for a Russia ETF (though at least there would be some protection of the ETF-held ADRs, as a custodian bank takes on the security risk but not the valuation risk).  While I don’t wish or expect this would ever happen, there is presently a larger likelihood of that occurring than the most liquid derivative contracts on the planet seizing up.

Also, not to bring up the painful past, but arguably more investors have been adversely affected by money market funds as some proved to be ticking time bombs during the financial crisis, relative to the stable $1.00 NAV.  Those funds subsequently received a temporary government backing to shore up confidence in their usage.  Inverse and leveraged funds received no such backing, nor are they ever likely to.

The final point is that it remains unclear what kind of market environment Larry envisions being problematic for leveraged ETFs. ProShares launched in 2006 and has endured the Lehman blow up, a 50% market decline, the SEC restriction of shorting financial securities, and then a 100% market increase.  Their products seemed to have worked as designed.  What is the market scenario where these ETFs can “blow up,” and what else is blowing up with it – the entire derivatives market, just swaps, only futures?  I would venture a guess that the market environment that takes down inverse and leveraged ETFs takes many more victims along with it.  I hope it doesn’t happen.