Dubious Derivatives

(August 13, 2008; September 19, 2008; August 17, 2011) Among the most popular exchange traded funds (ETFs) today are the so-called "ultra" and "ultra-short" ETFs offered by Proshares and Direxion.  With one very key caveat, these are some of the most useful and user-friendly funds available to investors.  The prices of these ETFs are designed to mimic various market indexes, styles, company sizes and sectors, but at twice the rate.  In other words, if the S&P 500 gains 1% in a day, the corresponding ultra ETF will gain 2% (or 3% in the case of Direxion ETFs).  The obvious downside is that losses are equally magnified, so you don't want to put a lot of money in an ultra ETF at the wrong time.  For every ultra ETF there's also a corresponding ultra-short ETF that moves in the opposite direction of the market, so these funds gain 2% when the market falls 1%, making them ideal bear market funds in theory.

The trick behind these ETFs is that they use derivatives, which means they are not invested in actual stocks. Derivatives include things like options, futures, and swaps, which are contracts between two parties that set forth rules for one party to pay the other party in the future, depending on the price of a stock, commodity, market index, etc.  One obvious shortcoming of a fund that uses derivatives instead of actual stocks is that investors don't get any dividend payments, but there's another problem that's potentially much bigger.

Racehorses offer a quasi-analogy for comparing derivatives and stocks. Buying a racehorse is like buying a stock. If the horse that you own wins a race and collects a prize, that's like having the stock pay you a dividend. If you then sell the horse for more than you paid for it, that's like buying a stock low and selling it high - you've made a capital gain.

However, you can also make money by betting on a horse in a race.  The only trick is that you need other people to bet against that horse - otherwise, whose money will you take when the horse wins?  Now, at the racetrack, all of the bettors have to pay their money ahead of time, so you know that the winning bets will indeed collect their rewards.  Thus you can make money on a horse without ever buying it, selling it, or collecting any of the prize money.

Derivatives are the stock market equivalent of betting on a horse. For every person who makes money on the winning side of a derivative, there is someone on the other end who loses that same amount of money. The problem is that, unlike the racetrack, there is no central holding area where all of the potential derivative payouts are kept. Most of the time this isn't a problem, but in the event of a stock market crash accompanied by a major financial meltdown, it's possible that some derivative participants on the losing end will run out of cash before they meet all of their payoff obligations to the bearish derivative "winners."

Thus, derivatives buyers, and ultra- and ultra-short ETFs that use derivatives, may see people on the losing end default on their obligations, much as banks are seeing homeowners default on their mortgages. These derivative contracts would then be devalued or "written down" just as mortgage-backed securities have been.  Inverse and ultra-short ETFs which use derivatives to move in the opposite direction of the market might not go up in price during a major crash. In fact, if there were a major financial catastrophe, inverse ETFs might actually go down in price during a market crash when they should be skyrocketing.

My concern about these derivative-based ETFs was vindicated on September 19, 2008 when the Proshares short and ultra-short financials ETFs (SEF and SKF) stopped trading for two hours.  This was right at the beginning of the final steep market plunge that ended in early October 2008, and since the market collapse was being driven by a mortgage and banking crisis, it's safe to assume that there weren't any more bullish financial investors to bet against.  Thus, for a brief period at least there was no money left to give to bearish bettors in the event that financial stocks tanked. The announcement by Proshares on that morning was predictably vague about the cause, and said only that they were
not expected to accept orders from Authorized Participants to create shares until further notice. Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets today, but may trade at prices that are not in line with their intraday indicative values.
One can only imagine what would have happened if governments hadn't stepped in to bail out all of those irresponsible "too big to fail" banks and other financial institutions.  We might then have had a full-fledged global financial meltdown, and there would have been more than one ultra ETF in trouble, and it would have been more than a 2 hour pause in trading.

Fortunately there is a way to make money during a catastrophe without having to bet with derivatives: it's called shorting (or short-selling or selling short).  Shorting a stock seems rather strange and complicated at first, but it's actually pretty simple. When you short a stock, you replace someone else's stock holdings with cash by selling their stocks on the market, and then agreeing to replicate the price motion of their former stocks by either adding your own cash to their account if the price goes up, or taking money from their account if the price goes down. Shorting is easy to do in practice through a broker, because you don't have to actually manage any of the things I just described; all you have to do is click "sell short" in your online account to open a short position. If you short stocks and the market crashes, the simple result is that you end up taking money from the people who think they own the stocks. There's no contract involved. The cash which is owed to the short seller is actually sitting there in an account, and is not just an I.O.U.

For those of us with tax-free or tax-deferred retirement accounts, shorting any kind of security (stock or ETF) isn't allowed, but there are funds out there that will do the old-fashioned shorting for you, and I affectionately call these my Armageddon funds because they will make money in an apocalyptic stock market crash even if the derivatives market collapses.