ETFs: Cry Transparency
A common thread runs through the Wall Street disasters that occurred at financial institutions like Goldman Sachs(GS), AIG(AIG) and funds championed by crooks like Bernie Madoff. Lack of transparency, combined by momentarily stellar returns, has caused otherwise-savvy investors throughout time to look the other way while stepping into the pit of despair.
The unsustainable institutions often use derivatives and leverage to achieve returns. Investors doing their homework may feel overwhelmed by the “It’s too complicated for you to understand” explanation and placated as their returns reach higher.
As ETF strategies become increasingly foggy, there is cause for concern. In the triple-down world of leveraged funds like Direxion’s Daily Financial Bull 3X(FAS) and derivatives doused arena of commodity products like U.S. Natural Gas(UNG), ETFs are getting more complicated as regulation looms. What makes this phenomenon particularly frightening is the yawning gap between investor expectations and reality.
Both leveraged and futures-based commodity ETFs have been under attack, largely for the strategies that these funds employ. To be sure, these funds actually execute these strategies but they are probably inappropriate for the bulk of investors.
UNG and U.S. Oil(USO) use a combination of futures and swaps to synthetically track the spot price of oil. As regulations loom on the horizon, UNG has been selling futures and buying swaps. Both UNG and USO have complex strategies and the CFTC investigation may force these funds to add more layers of complexity in a move to survive.
ProShares UltraShort Real Estate(SRS) has been sued by a customer who believes that the company was not forthcoming about its strategy. Before, if you read the fine print, this strategy may become obvious but it is couched in language that an average investor may not understand. Recently leveraged fund issuers like ProShares, Direxion and Rydex have added more explicit warnings to their websites.
The frightening thing about these products is the unassuming way they appear. Their names are straightforward and approachable. One might say, “I’d like to buy oil — U.S. Oil sounds like a straightforward pick.” Buying UNG or USO, however, is not a straightforward ticket to commodities investment. These funds are fraught with issues like contango and creation limitations.
The fact that they are ETFs is also disarming. Investors have long flocked to ETFs for their “transparent” reputation, an open book compared to traditional mutual funds. Traditional ETFs certainly live up to this creed. Equity-based ETFs have a price-it-yourself type of access to their holdings.
Visiting the website of State Street’s(STT) Financial Select Sector SPDR Fund(XLF), one can easily find the information on the fund’s low expense ratio and underlying index. For a gross expense ratio of 0.21%, investors can gain access to a basket of securities like JPMorgan Chase(JPM) and Wells Fargo(WFC) that are catalogued and updated daily. Potential shareholders can discover exactly what is in their investment simply by visiting the Web site.
Investors visiting the website of ProShares Ultra Financials(UYG) are greeted by a similar set of holdings and an expense ratio of 0.95%. How can a fund demand such a higher price with similar underlying holdings? It all leads back to the small print on the daily holdings page for the fund.
Beneath the straightforward list of UYG holdings, ProShares notes that “ProShares may invest in equity securities and/or financial instruments (including derivatives) that, in combination, should have similar daily price return characteristics to the fund’s benchmark.” These derivatives are the meat of this fund and drive the fund’s daily performance.
Without these derivatives, ultra-long and ultra-short ETFs would not work. Why then aren’t they listed alongside the underlying equities? These contracts are complex securities with varying levels of risk, and investors can never be sure exactly what they are getting.
If an investor is sophisticated enough to invest in leveraged or commodities funds, they should be savvy enough to understand how these funds deliver returns. Transparency problems have hobbled some of the great institutions of our time. ETFs investors should demand to easily see what they get.
