Felix Salmon

Why guru ETFs beat human gurus

Felix Salmon
Nov 21, 2013 01:09 UTC

Wall Street is no place for shrinking violets, but even by New York standards, Jason Ader has some serious chutzpah: he said today that “the proliferation of index funds and exchange traded funds” helps activist investors like himself make money.

These big investors are rarely holding “management accountable for underperformance and are not pressuring boards to hold management accountable for underperformance,” Ader said at the Reuters Global Investment Summit.

Funds run by well known activists, including Jeff Ubben of ValueAct, Barry Rosenstein of Jana Partners, and Carl Icahn, have returned roughly 14 percent on average so far this year, twice the amount that the average hedge fund has delivered, partly because they cajole businesses into running their operations better, the activists say.

In principle, this makes sense. One common criticism of passive investing is that if everybody did it, then there would be no price discovery — and that the more passive investors there are, in a market, the easier it becomes to take advantage of them with a little bit of sophisticated analysis and/or activist investing.

But the point at which passive investing becomes self-defeating is a bit like the point at which the gradient of the Laffer curve turns negative, and tax hikes cause revenue losses rather than revenue gains: both points are far beyond any state of the world that obtains in real-life America. Passive investors are still a minority of all stock-market investors — and, what’s more, they could easily become a majority without doing any harm to the markets’ price-discovery abilities. The only thing that matters is that there’s a reasonably large number of active marginal price-setters. Since there always will be a reasonably large number of active marginal price-setters, no one ever need fear that the rise of passive investing is going to become self-defeating.

In any event, it’s a simple mathematical truth that activist investing has not outperformed passive investing this year. That 14% return looks downright miserable, if you compare it to the 25% year-to-date return on the S&P 500, or any index fund which tracks it.

Of course, if your dream is to beat the market, then you’re going to have to invest in something other than a passive index fund. But don’t kid yourself that the rise of the passive-investment gospel is going to make your life any easier: it isn’t. And don’t kid yourself, either, that paying 2-and-20 to anybody is a sensible way to try to achieve your goal. Indeed, there’s an increasing number of relatively low-fee ETFs which aim to replicate the results you’d get from investing with some of the biggest-name investors in the market. (Or, of course, you could just buy stock in Berkshire Hathaway.)

These “guru” ETFs, as they’re known — one of them even trades under the GURU ticker symbol — are an outgrowth of the hedge-fund replication industry, and have varying degrees of sophistication. Charles Sizemore does a good job of comparing them: ALFA is incredibly complex; GURU is simpler; the forthcoming iBillionaire ETF (plugged by Tim Fernholz under the headline “How to copy a hedge fund billionaire’s investment plan”) is downright naive, based as it is on a strategy of simply looking for S&P 500 components in the 13F filings of certain billionaire investors.

It’s easy to laugh at these things — 13F filings, for instance, are lagging indicators which don’t give any indication of how hedged an investor is, or whether they’re putting on some kind of relative-value trade, or what their exit strategy might be. But never mind all that: iBillionaire has lots of pretty charts showing consistent outperformance over various time periods from one month to 8 years. This is “hypothetical” outperformance, of course — and surely the index has been structured, and the billionaires in it carefully chosen, so as to make the index look as attractive as possible from today’s perspective. Here more than ever, buyer beware: it’s all but certain that the index’s outperformance will start to disappear now that its immune to selection bias.

But the fact is that not all ETFs need to be passive cap-weighted index-trackers, and buying one of these guru ETFs is no sillier than buying a typical actively-managed mutual fund. In fact, it’s probably more sensible, since the discipline of the ETF strategy is baked in to its structure, and it’s harder for an all-too-human manager to make silly mistakes. On top of that, no matter how high the fees on these ETFs might go, they’ll never come anything close to the kind of fees being charged by Jason Ader and his ilk. The ETFs just sit back and follow a predetermined strategy, rather than feeling the need to do the rounds of media organizations, spouting random “conviction trades for the coming year”. Cheaper and quieter? It’s a winning combination.


“One common criticism of passive investing is that if everybody did it, then there would be no price discovery — and that the more passive investors there are, in a market, the easier it becomes to take advantage of them with a little bit of sophisticated analysis and/or activist investing.”

This is somewhat true, but more important is the quality of others that you are competing against. Even if the market is 90% passive, that share in a sense is immutable – they simply do not partake in price discovery. It is the other 10% whom you are competing against. You only “outperform” when you guess better than they do.


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Financial innovation of the day, Winklevii edition

Felix Salmon
Jul 2, 2013 17:59 UTC

You can see why they called it the Winklevoss Bitcoin Trust. Without their name in there somewhere, they would never have gotten a respectful thousand-word article in the NYT just for making a speculative SEC filing. To be clear: this thing is a really, really silly idea, from a pair of brothers whose main ambition, these days, is to be the biggest helminths in the bitcoinverse.

As I explained back in April, bitcoin is a combination of two things: it’s a very interesting payment mechanism, and it’s also a highly stupid and speculative store of value. With their new product, the Winklevii are basically separating the two, and selling — for an extra fee — the stupid-investment part of bitcoin without any of the benefits of the much more interesting and useful payments-mechanism aspect. As Peter Thal Larsen points out, you might as well buy an ETF which holds dollars.

Still, if you want to own bitcoins, and you never want to spend your bitcoins, and if you want to pay the Winklevii for the privilege of looking after your bitcoins on your behalf, and if you trust that the Winklevii, after putting out a huge shingle saying “millions of dollars worth of bitcoins stored here”, won’t get hacked and lose all their coins, — then, well, then I’m afraid I have bad news for you. Which is that the SEC will never, ever, approve this product. After all, this is an asset that senators want to ban, an asset which is probably illegal under US law, and an asset that is mainly known for its ease of facilitating money laundering, tax evasion, and the purchase of contraband material. It’s hard to see why the SEC would do anything whatsoever to legitimize that asset as an investible asset class.

Still, the Winklevii have made their SEC filing now, and have received lots of press around it. Just by doing that, before getting any kind of regulatory approval, have helped to make the idea of bitcoins just that tiny bit more legitimate. They’re even trying to invent a whole new asset class — they call it the DMBA ETP, for Digital Math-Based Asset Exchange-Traded Product — in the hope that they can somehow jump onto the ETF bandwagon with the same unerring sense of timing they displayed with their initial bitcoin announcement. (Price of bitcoins then, on April 11: $165. Price of bitcoins today: $90.)

ETFs themselves are looking a bit shaky right now: the market support they need from “authorized participants” doesn’t seem to be able to keep up with the billions of dollars flowing in and out of the asset class. ETFs have never been more popular as an asset. At the same time, the big banks — which are needed to underpin the market — “may no longer be willing to support ETFs in volatile markets”, in the words of the FT. The result, Bloomberg reports, is that many of the less liquid ETFs are seeing increasingly alarming gaps between their own values and the values of the securities they represent.

On Saturday, Blackrock — the world’s largest provider of ETFs — became so worried about all of the negative chatter surrounding the asset class that it put out a truly extraordinary statement, saying that “during the market volatility of the past few weeks, ETFs performed precisely as they are designed to do”, and that (in bold print) “more and more ETFs are becoming the true market”. In other words, if the price of an ETF is lower than the price of the underlying stocks, then, well, that’s just because the ETF is a better indication of the true market price than the stocks themselves are. This is a truly glorious argument, in the Humpty Dumpty sense of the word:

Said Humpty Dumpty: ‘There are three hundred and sixty-four days when you might get un-birthday presents —’

‘Certainly,’ said Alice.

‘And only one for birthday presents, you know. There’s glory for you!’

‘I don’t know what you mean by “glory”,’ Alice said.

Humpty Dumpty smiled contemptuously. ‘Of course you don’t — till I tell you. I meant “there’s a nice knock-down argument for you!”‘

‘But “glory” doesn’t mean “a nice knock-down argument”,’ Alice objected.

‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

Here, Humpty Dumpty is Blackrock, and Alice is, well, Izabella Kaminska, I guess.

As Jonathan Kahn notes today in a letter to the FT, it’s never particularly reassuring, in the wake of the financial crisis, that an asset class is supported by large banks who have a financial incentive to provide liquidity to the market. Because when you really need that liquidity, those banks are going to be nowhere to be found.

If this is a problem with ETFs in general, it’s a particularly enormous problem with the Winklevii’s monstrosity. So, rather than paying any further attention to their ridiculous stunts, I would advise a much more sensible alternative for anybody looking for an easy and legitimate way to buy and store bitcoins. Here’s a press release from OpenCoin today, announcing that anybody with a Ripple account — something you can easily set up for free, online, in any currency, and which I explained back in April — can now use that account to pay anybody in the world in bitcoins. A Ripple account, then, can be used to store bitcoins, if that’s what you want to do, or you can keep your money in a real currency instead: it’s up to you. And whatever form your money is in, you can use it to pay for things in bitcoins as well. In other words, it does everything that the Winklevii are offering to do, plus a lot more, without charging a management fee.

Ripple, bitcoin, ETFs — all of these are financial innovations, and financial innovations have a deservedly bad name these days. All of them have potential downsides. But most of them at least serve a real purpose, and have their defenders. The Winklevii, muscling in to the financial-innovation game, are being much more selfish about the whole thing. They’re going to fail; I just hope they don’t cause too much harm to others in doing so.


1. Start asking the kind of questions you ask here about the ability of a bitcoin to store value, and next thing you know you’ll be asking the same questions about most of the major world currencies (including USD), and the answers aren’t that different. Yes, the “full faith and credit…” and so on and so forth, but if/when it ever comes to the point where that backing is truly needed, is the same moment where it’s not worth the paper it’s printed on.

2. If you’re going to criticize, think a few steps into the future. You’re standing on the sidelines throwing mud at the first few moves of a chess match. Please, intelligently debate how bitcoin & new methods of payment/currency might play out, but this article is simply a weather report on what’s already happened. No value added.

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What’s driving the Total Return ETF?

Felix Salmon
Jul 18, 2012 16:13 UTC

When Pimco’s Total Return ETF launched earlier this year, it was clear what the biggest risk was:

The inability of the PIMCO Total Return ETF to use derivatives will prevent a perfect correlation and affect performance. The size of that difference will be watched closely and will play a role in the format’s acceptance by investors.

Peter Lewis, executive director of liquid markets at Nomura Securities International in New York, said while some deviation will not have a big effect on the acceptance of active ETFs, a wide gulf would be a point of objection.

The total return ETF is supposed to mimic the performance of Bill Gross’s flagship Total Return Fund. And the bad news is that it has failed to do so, by an enormous margin: there’s a whopping 350bp gap between the two already, and that’s just performance since March 1. Oops.

But here’s where things get interesting: the Total Return ETF has actually outperformed its namesake fund, rising 7.7% during a period when the older fund rose just 4.2%. And suddenly the investors who were worried about basis risk don’t seem to be nearly as worried any more:

Bill Gross’s Total Return Exchange Traded Fund has doubled its assets in less than two months, as performance trumped that of the world’s largest mutual fund, whose strategy it mimics…

Pimco Total Return ETF (BOND) reached $1 billion in net assets on May 21. Because the ETF is still much smaller than the mutual fund version, it can snap up notes with the biggest potential returns.

This is worrying on three different levels. First of all, it shows that investors still haven’t learned one of the first lessons of financial markets, which is that anything which can outperform substantially is also at risk of underperforming substantially. If the ETF is doing much better than the bond fund it’s meant to mimic, that’s not some happy reason to pile in, it’s a big red flag.

Secondly, this shows that sophisticated, actively-managed ETFs simply can’t do what they’re designed to do. Pimco is deliberately vague on the question of whether the ETF is meant to replicate the larger fund, or whether it’s just meant to follow the same strategy. But either way, a 350bp difference between the two, in the space of just four months, is pretty definitive proof that they’re very different animals indeed.

And finally, it’s evidence that the $263 billion Total Return mutual fund is simply too big at this point. Here’s the theory:

“It’s very difficult to beat the market when you are the market,” said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $38 billion. “Any choices you make will have an outsized impact when you’re smaller and more nimble. It stands to reason that there will be more opportunities that you can take and fly below the radar”.

I’m not completely convinced: the Total Return Fund can move very fast, when Bill Gross is so inclined. On the other hand, while there are good reasons why you might want to be invested in a $2 billion fund rather than a $20 million fund, it’s much less clear why an investor is better off in a $200 billion fund than in a $2 billion fund. Economies of scale, at some point, become diseconomies of scale.

And then there’s the simple question of Bill Gross’s finite attention budget: if he’s picking out smaller opportunities for his baby ETF, does that mean that at the margin he’s neglecting his main charge?

On top of all that is the fact that it seems to be decidedly non-trivial to work out the difference in performance between the ETF and the main fund. On July 6, for instance, Yahoo Finance reported that the ETF was up 6.2% since March 1, while the Total Return Fund was up 3.2% — a difference of 300bp. The same day, Bloomberg had the same 3.2% return for the fund, but said the ETF was up 6.8%, for a difference of 360bp.

All of which says to me that it’s very early days to be investing in the young and decidedly untested asset class of actively-managed ETFs. Pimco’s big institutional clients, with their billions of dollars invested in the main Total Return Fund, certainly aren’t moving their money over to the ETF just yet. If and when they do, it might be time to revisit. But for the time being, it’s probably best to just observe BOND’s nascence from the sidelines. Like all babies, it’s pretty much impossible to tell how it’s going to grow up.


Two things – there is no mention of the BarCap Agg’s performance during this time period, which both fund and ETF have dominated. Also, getting a quote from Doubleline, arguably PIMCO’s biggest up and coming competitor in the core bond space, on how PIMCO is too big seems a bit biased, no?

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Chart of the day, ETF size edition

Felix Salmon
Jan 23, 2012 15:12 UTC

I’m sorry I missed Devin Riley’s excellent post when I was writing about ETFs on Friday. Here’s his chart:


What you’re seeing here is a y-axis ranking assets under management: the biggest funds are lower down. The x-axis ranks launch date: the earlier the fund launched, the further it is to the left. The correlation could hardly be more obvious. If you want to be a hugely successful ETF, by far the best thing you can do is to launch early.

Here’s Riley:

Launch rank explains up to 81 percent of an ETF’s rank in its segment. More to the point, in 71 percent of all segments, the first-mover had the most assets.

To me, that was surprising.

Given that ETF issuers compete fiercely on expense ratio, index tracking, and marketing materials to win investors, it’s a little disheartening to learn that so much of an ETF’s success is tied to its launch date.

This is surely good for consumers, at least so long as people continue to launch new ETFs. Because when they do so, they’re going to have to compete aggressively on fees, if only because that’s the only way that they’ll ever be able to gain any kind of market share. In turn, the new low-cost competitors will keep fees on the market leaders low and falling.

In theory, eventually, the supply of new ETFs will dry up, and the less successful competitors will drop out of the market. At that point, the market leaders might in theory be able to start raising their fees. But I’m not so worried about that: the best way to increase fee income is to keep your fees low and constant, while increasing your assets under management. Any hint of fees going up is only going to attract new competitors, or incentivize existing competitors to lower their own fees.

So for the time being it’s fine to just buy whatever the biggest ETF is in any given asset class, and sleep easily at night. There’s a small risk that in future you might end up invested in something suboptimal, but you’ll probably hear about it if that happens. Investing isn’t normally this easy, so let’s just celebrate the idea that this strategy seems to work so well, and concentrate entirely on asset allocation rather than spending lots of time second-guessing which of many ETFs to choose from.


There is an odd mixture of doubtful points in that argument. Firstly, as dWj points out, I suspect a heavy survivorship or, more to the point, selection bias. What about all the ETFs that went out of business over that time? The very early ones would rank high on the Launch scale (i.e. left) but at the bottom of the AUM scale (i.e. top). So there’s a potentially big bunch of observations missing in the upper left end of the chart.

Also, “Given that ETF issuers compete fiercely on expense ratio, index tracking, and marketing materials to win investors”, it’s a little dishartening that he doesn’t take all these variables into account when making such a strong statement. R2 of 81 percent raises more doubts than anything else in general.

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ETF datapoints of the day, market-share edition

Felix Salmon
Jan 20, 2012 23:03 UTC

Conceptually, it makes sense that ETFs would be a winner-takes-all phenomenon. Expenses rise much more slowly than assets, which means that the bigger a fund gets, the cheaper it can be. And given that ETFs compete first and foremost on expense ratio, money is likely to pour into the cheapest-and-biggest funds, which allows them to get even cheaper. And so on.

So this chart, from Lipper, comes as little surprise.


In many ETF categories, it turns out, one ETF has the lion’s share of the market — Vanguard in total stock market ETFs, Market Vectors in precious metals, iShares in TIPS and investment-grade bonds.

So one would expect that those big dominant funds would be significantly cheaper than their competition — that would explain their dominance. And, one would be right — if you just look at precious metals. But elsewhere, that’s not the case.

Among total stock market ETFs, the Vanguard VTI fund is extremely cheap, charging just 0.06%, but the Schwab US Broad Market ETF charges exactly the same, and has just 0.46% of the assets in the class.

The cheapest investment-grade bond ETF is the Vanguard Long-Term Corporate Bond ETF, with an expense ratio of 0.14% — but it has only 2.3% of the purple pie. The iShares is only 1bp more, but has 90% of the assets.

And when it comes to TIPS funds, all of the big ETFs — iShares, Pimco, and SPDR — charge the exact same 0.20%. But iShares gets nearly all the business.

Now we’re not talking, here, about the kind of small, illiquid ETFs which can easily underperform. All of these funds are big enough that, to a first approximation, they’re all as safe as each other.

But still, at the margin, a big ETF is always going to be safer than a smaller one. And I suspect that most of these funds have a first-mover advantage, and that their competitors might well be losing money in their attempt to stay competitive with the giants in the space.

Is there any reason, for an individual investor, to choose one of the smaller ETFs rather than the big ones here? I don’t think so. Big mutual funds can be lumbering and dangerous, but big ETFs just have that much more clout in things like the repo market. And all ETFs get front-run by algorithmic high-frequency traders in exactly the same way: I don’t think big ones suffer more on that front.

My feeling is that if you choose the big fund, the fees might come down as it gets bigger; if you choose something small like the Schwab broad market fund, by contrast, the fees might well go up if its managers give up trying to compete with Vanguard. So if you’re going to buy one of these ETFs, you might as well follow the crowd. This is one area where contrarian investing will likely get you nowhere.


It’s all about the bid/ask spread. Most users of ETFs are relatively high-frequency trading hedge funds, so that matters a lot more than a couple basis points on fees.

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How to make ETFs less risky

Felix Salmon
Oct 25, 2011 19:37 UTC

Harold Bradley and Bob Litan made some very good points about ETFs in their Congressional testimony last week — testimony which Paul Amery today greets as “a mixed bag”. But it’s hard to argue with this:

We have enough history with financial innovations to at least raise questions when we see an innovation growing at very rapid rates. ETFs are no exception. We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses. When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around.

There’s a tragedy of the commons going on here: for any given individual investor, ETFs make a huge amount of sense. But if individual investors — and a lot of institutions, too — all pile into ETFs en masse, then stocks lose their price-discovery role, and large deleterious effects can start emerging.

For instance, one big reason to buy a market index rather than a handful of individual stocks is that the index provides diversification. But that diversification is disappearing as people pile into ETFs:

High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time.

Here’s one particularly striking chart:


This isn’t the S&P 500, which has even higher correlations. It’s just large-cap stocks. Which are all moving together in lockstep — much more than they were even in 1987, and more even than they were in the Great Depression.

Amery comments:

It’s common sense that the more investors buy and sell equities via index trackers like ETFs and futures, the higher you’d expect internal index correlations to be. And since ETFs have been growing in importance, the greater you’d expect their impact on index stocks’ co-movements to be.

Researchers at JP Morgan came to similar conclusions last year, arguing that high-frequency trading is also playing a role in boosting internal index correlations.

There’s nothing forcing investors, by the way, to purchase those index trackers where such herd effects are most prominent. You don’t have to buy the S&P 500—you could easily choose an index put together in different ways and featuring different stocks. Arguably, avoiding “overowned” indices should be near the top of a list of any investor’s priorities.

This I find a bit less convincing. As the above chart shows, there are very high co-movements even outside the S&P 500, it’d be hard to find any kind of broad stock index without a high correlation. And if you only get a small benefit in terms of extra diversification, then the costs, in terms of higher ETF fees for unusual instruments, are likely to be higher than the benefits from diversification.

That said, there are lots of people who make money from the huge amounts of cash sloshing into ETFs, and especially from the way in which the S&P 500 ETFs have to rebalance every time the index changes. And the more popular S&P 500 ETFs become, the more we’re all just funneling cash — some 30bp per year, it’s estimated — to those rebalancing arbs.

What is to be done? At the margin, Bradley and Litan’s idea that ETFs should have tighter circuit breakers than individual stocks is a good one. Amery reckons that “it’s important not to leave loopholes where trading in the ETF is stopped, but that in most of the underlying stocks can carry on” — but I don’t see that. If you want to keep on trading individual stocks, that’s fine — just stop the ETF driving their movement.

But fiddling around with circuit breakers won’t make any difference on a day-to-day basis. And cracking down on ETFs more generally risks throwing the baby out with the bathwater. My feeling is that the best thing to do here is simply adopt the kind of financial-transactions tax that the Europeans are talking about — a 0.1% Tobin tax on all ETF trades. That would drive away the day-traders and rebalancing-arbs from the ETF market, leaving it to the buy-and-hold investors that ETFs are very good for. It can’t do much harm, and it could well do quite a lot of good, from a systemic-risk perspective.


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The harm done by levered ETFs

Felix Salmon
May 1, 2011 22:26 UTC

Kid Dynamite and The Analyst have taken issue with my post about levered ETFs. We’re all in agreement that they shouldn’t be held for a period of longer than 1 day. But their argument is basically that the SEC can’t and shouldn’t protect people from their own stupidity. Here’s the Analyst:

As should be extremely obvious at this point, understanding how these ETF’s work is not rocket science, and it does not take much time/effort to do. If you do a quick google search for “how do leveraged etfs work” returns a large number of posts, most of which answer the question with little ambiguity.

Let me put this as nicely as possible: You have to be self-defeatingly ignorant/naive/lazy to trade these things without learning about them. If you have an internet connection, you’d actually have to go out of your way not to pick-up some basic knowledge about how leveraged ETF’s work just by sheer happenstance. The information is EVERYWHERE, easy to find, and just as easy to understand for anyone capable of opening a brokerage account.

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

What worries me here is that we’re taking rules which apply to stocks and applying them to levered ETFs, even when levered ETFs are very different creatures from stocks. Stocks are permanent long-term stores of value — ownership stakes in something real in the world. Levered ETFs, by contrast, are pretty much guaranteed to go to zero eventually; the only question is how long they will take to get there. That’s not a problem for people who hold them on an intraday basis, as trading vehicles. But they trade on the stock exchange with a stock-like ticker symbol, and they look similar to unlevered ETFs which do things like replicate the S&P 500, and which really are long-term investments. So it’s easy to see where the confusion arises.

What I’m not getting from KD or the Analyst is any good reason why levered ETFs should exist. What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

It’s one thing allowing people to invest in individual stocks which can be highly risky investments — that’s fine, because there’s a strong social upside to allowing companies to raise capital on the stock market and allowing individuals to buy those stocks. But there’s no such social upside to levered ETFs, and if they disappeared tomorrow, anybody using them the right way could very easily put on the same trades just by using their margin account. So if there’s good reason to believe they’re causing harm, and no reason to believe they’re causing any good, why keep them?


Out of the universe of leveraged ETFs I can think of one very large and prominent category that has a valid purpose. The purpose is capital preservation, and the category is the leveraged inverse ETF.

First, understand my point of view. I have self-directed investments, but do not desire to allow trading to take over my life. I am not of the speculative mindset and do not try for lopsided killings. I would prefer to pick good stocks and buy and hold, but a bear market makes that a less-than-optimal strategy. Enter the leveraged inverse ETF as a hedging tool, doing the thing it was designed to do.

Once intellectually in command of the leveraged inverse ETF, I have new freedom. In a down market I am still free to assemble my portfolio of equities and conventional ETFs and hold it, rebalancing as my views of the long term gradually change. I can keep my shares and collect dividends. On up days I do not have to own any shares of my favorite leveraged inverse ETF. My thought is that I am always looking for a good reason to get rid of those shares, so I unload them as soon as things start looking bullish. Good days take care of themselves.

On a down day, one that I had a strong sense in advance was going to be a down day, I can load up on leveraged inverse ETFs and do better than just avoiding losses. Those days are pretty rare, but they do occur.

More frequently, in choppy trading, when the market dynamic is obscure, even baffling, buying into a leveraged inverse ETF can neutralize change in the value of my portfolio. I can just decline to make wagers. I can have no large gains or losses for the entire confusing, inscrutable day. If, on a particular day, I’m tired, or sick, too occupied with my day job or playing with the grandchildren, I can just set the market down, with fair safety, by neutrally hedging my portfolio first thing in the morning and selling out my position in an inverse leveraged ETF at 3:59 PM.

Case in point. Today, I couldn’t understand the market. Asia and Europe were down, but good news came from Michigan (consumer confidence), Chicago (purchasing managers) and Washington (personal income). So, things were unclear. Looked like it might go up, but ended up going down. I hedged out of the whole mess using ProShares SDS, and got some work done. Had I done nothing, I know I would have lost about 2.50%, because my portfolio tracks the S&P. As it stands I lost 0.08%, a very small amount. I sold every share of SDS at the end of the session. Monday might as well be years away.

I think leveraged inverse ETFs can reduce risk, ulcers and the amount of time you have to spend babysitting your portfolio, assuming that is not the thing you most love to do.

Posted by thiggins | Report as abusive

Why the SEC should look at levered ETFs

Felix Salmon
Apr 30, 2011 02:22 UTC

TBT, the ProShares UltraShort 20+ Year US Treasury fund, is an ETF which returns double the daily decline in an index linked to long-dated government bonds. There are 173 million shares of TBT outstanding, which at a price of $35.65 apiece, means that more than $6 billion is tied up in TBT shares. But average daily volume is just 10.7 million shares — which means that the overwhelming majority of TBT shares are not traded on any given day.

The helpful bloggers at Symmetric Info have explained in great detail — here’s Part 1 and Part 2 — why this is bonkers. But suffice to say that no one should ever hold a leveraged ETF overnight. These things are intraday trading vehicles; they’re not medium-term or even short-term investments.

Given how many people are clearly Doing It Wrong when it comes to TBT, I think there’s a strong case for the SEC to step in here and take a very hard look at TBT in particular, and levered ETFs in general. If day-traders want to day-trade using ETFs, that’s fine — and they can bring their own leverage, if they’re so inclined. But ETFs with embedded leverage are clearly being bought by people who aren’t day-traders at all, and who have no business buying these securities. It’s the SEC’s job to protect those people. It should get on the case.


“no one should ever hold a leveraged ETF overnight” may not be true. This article http://ddnum.com/articles/leveragedETFs. php says that the above statement is a myth and that leveraged ETFs CAN be held long term. I would add another qualification to that article: PROVIDED THAT THE VOLATILITY OF THE ETF IS LOW ENOUGH it may be held long term. Indexes have relatively lower volatility than other securities so may be good candidates for long term holding in a leveraged form.

Posted by inoddy | Report as abusive

ETFs jump the shark, FactorShares edition

Felix Salmon
Feb 24, 2011 21:29 UTC

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.


“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