ETFs jump the shark, FactorShares edition

By Felix Salmon
February 24, 2011
get-go:

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Sometimes, financial innovations seem like a good idea at the time, and it’s only later, after everything has gone pear-shaped, that it becomes clear we would have been much better off without them. Other times, financial innovations are clearly a bad idea from the get-go:

Factor Advisors, a New York-based asset management firm, announced today the launch of FactorShares, the first family of spread exchange traded funds (ETFs) that allow sophisticated investors to simultaneously hold both a bull and a bear position in one leveraged ETF…

FactorShares ETFs are capital efficient, targeting a daily leverage ratio of 4:1… FactorShares ETFs seek investment results for a single day only, not for longer periods.

Some investments, in things like hedge funds or private-equity funds, are considered so risky that you need to be qualified to buy them. Other investments — public stocks listed on the NYSE are a good example — can be bought by just about anybody. FactorShares, incredibly, are in the second category.

Needless to say, no one with an ounce of common sense should go anywhere near these things. Even if you’re convinced that bonds are going to outperform stocks, you should never touch FSA, the fund which gives you a 2x leveraged long position in Treasury bonds combined with a 2x leveraged short position in the S&P 500.

Just look at the official FactorShares FAQ if you want some of the reasons: the funds certainly should never be held overnight, and “may experience tracking error intra-day”; there’s “a compounding effect and tracking error”; the leverage fluctuates and “could be higher or lower than an approximately 4:1 leverage ratio”; there’s the inevitable Management Fee, of 0.75%; “other fees apply including brokerage commissions”; the shares “are not mutual funds or any other type of investment company within the meaning of the Investment Company Act of 1940, as amended, and are not subject to regulation thereunder”; the Managing Owner has been a member of the National Futures Association only since December 2009; the shares “may be adversely or favorably impacted by contango or backwardated markets”; you have to deal with a K-1 form for tax purposes at year-end; and I’m sure there’s lots of other stuff in the various prospectuses.

What confuses me is why the SEC, the NYSE, and other institutions who consider themselves to be protecting individual investors would ever allow these things to trade openly on the stock exchange in this manner. This isn’t a company raising equity capital so that it can invest in the real economy and grow and thrive. Instead, it’s a pointless, parasitical, negative-sum financial monstrosity which will probably make a modest sum for its sponsor and lose money, on average, for anybody who invests in it. It doesn’t even serve any legitimate hedging purpose.

ETFs looked like a good idea when they started replacing index funds. But the more that this kind of thing happens, the more of a bad name they’ll have. Let’s hope regulators wake up and shut this scheme down, and lots of similar ones too. People who buy these things aren’t “sophisticated investors”; they’re really not investors at all. If they want to gamble, there’s always Vegas.

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Comments
7 comments so far

Not all new products qualify as innovative. And most financial “products” (a better term would be “scheme” or “scam”) are certainly not innovative, except maybe from the seller’s point of view.

If I were to expand on Paul Volcker’s comment that the ATM has been the only real financial innovation, I would add single use credit card numbers (unfortunately not available to everyone) and those new mobile phone apps that let you deposit checks by taking a photo of them with your smartphone (also not available to everyone). Other than that, most financial “products” that people call innovative are shell games.

Posted by KenG_CA | Report as abusive

ETFs are for lazy portfolio managers! ETFs create a disincentive to invest the old fashion way of research and analysis.

ETFs probably provide liquidity and capital mobility in some cases (e.g. emerging market ETFs) but other than that, they are just another avenue for fee-related income.

Posted by takloo | Report as abusive

I’ve never been clear on the benefits of ETFs over index mutual funds, if both are available for the same asset class. How many investors really need to be able to trade their positions intraday? There seem to be some asset classes that, perhaps for legal reasons, are better implemented via ETFs – e.g., commodities, where the use of derivatives in an ETF simplifies positioning, but is (perhaps) not possible in a ’40-Act fund. But that’s a technicality. And for those who want to short a sector, obviously ETFs are pretty handy.

But here’s the thing – if someone really wants to make the bet embedded in these long/short ETFs, what’s wrong with providing a vehicle for them? These things don’t look like a scam – they’re completely above-board and transparent about what they’re doing. So what’s the big deal for consenting adults?

Posted by FosterBoondog | Report as abusive

The nice thing about an ETF for a frequent trader is that you can buy or sell at any time instead of submitting an order that won’t clear until the closing bell.

The (typically) lower fees benefit long-term investors.

Otherwise not that much of a difference.

Posted by TFF | Report as abusive

FosterBoondog, did you miss the memo?
Suppose I’m in my 70′s and decide that I need to cash out some of my investment securities to fund my retirement expenses. But once *I* make that decision, I clearly _NEED_ that trade to happen … intraday??? … not just that, but NOW. Right NOW. Waiting till the end of the day would be absurd, inefficient, criminal, anti-capitalist … basically, robbery. Every SINGLE MICROSECOND from the time I decide to do this until the trade occurs is an abomination, and I’m thrilled that all the brightest minds in the country spend their (well-compensated, deservedly so) lives making sure my decision is enacted as instantly as the best of human technology allows. Go America!

Posted by bxg12 | Report as abusive

“Some investments, in things like hedge funds or private-equity funds, are considered so risky that you need to be qualified to buy them..”
——————-
While at the same time states are vigorously pushing lotteries, which are designed to separate the lower class from their money.

Posted by Loebner | Report as abusive
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