A few points on risk and size by Golem XIV.
People always say Follow the Money. You might do better to Follow the Risk.
Risk is the pollution created by the process of making money. So where you find people making one you will surely find them hiding the other. You’ll find both at the banks.
Banks have managed to convince the regulatory authorities – their regulatory authorities, and I use the word ‘their’ advisedly – to convinced them to count the creation and storing of risk as part of the banks contribution to the nation’s GDP. I wrote about how our governments count risk creation and storage of as part of the bank’s GVA (Gross Value Added) in What the Banks Contribute to GDP. Our government’s reasoning is that risk is an unavoidable by-product of the financial industry so the industry should get credit for dealing with the stuff. But imagine counting the creation and storage of radioactive waste as part of the value added of the nuclear industry? Would it not seem perverse to celebrate increases in the amount of waste being stored and see it as evidence of what a wonderful industry it was, rather than ask why they produced so much in the first place? Would it not seem odd to talk glowingly (sorry) of the increases in radiation levels being stored, and reward the industry accordingly, rather than ask if there might not be a safer, less radioactive way of generating power? It seems to me this is the situation we are in with banking.
So far so vanilla. Now lets look at how, as the ETF market has grown, the clever boys and girls of finance have found ‘innovative’ ways of pumping those ETFs up a bit, just like they did to Securities.
Use of Derivatives in ‘Synthetic’ ETFs
The main innovation in ETFs has been the creation of what are called ‘synthetic’ ETFs which instead of actually buying or even borrowing a basket of shares, use derivatives to track the value of the underlying market without the need to match its composition. Instead the Synthetic ETF enters into an asset swap agreement with a counterparty using an over-the-counter (OTC) Derivative. Before explaining what the heck that means let’s just look at how quickly the Synthetic market has grown.
Synthetic ETFs have grown very rapidly in Europe and in Asia. In Europe Synthetic ETFs are now 45% of the over all ETF market. Synthetics doubled their market share between 08 and 09.
The key to Synthetics is the Counterparty. What happens is the ETF Sponsor designs the deal, the AP (Apporved Participant. Usually one of the big banks or brokers) buys the basket of assets to make it, but then swaps that basket with the Counterparty for a different basket of assets in a derivative swap deal. However it turns out that rather too often for comfort, not only will the Sponsor and the AP be the same bank, but more often than not it will be the Asset Management branch of the same bank who will be the Swap Counter-party as well. It is quite common for the same bank to play all three roles. So a single bank creates the ETF, appoints itself as AP so it can fund it and then its Asset Management desk becomes the derivative counterparty in order to mutate the whole thing into a synthetic ETF. Think about what this does to the risk. What was market risk, where the risk was spread out across all the different shares, is now a single counterparty risk. The bank has effectively put all the ETF’s risk in one basket – itself.
How many of those holding ETF’s know what the ETF stands for? How many know how they work? How many understand the leveraged ETF’s and their risks? How many understand the hedging procedures? How many have actually created, priced, and hedged ETFs? The answer to all the above is probably very few. Despite being a relatively complex field within the creative finance industry, especially the exotic and leveraged versions, few people actually understand what they trade, and even less the risks involved with these products.
A few weeks ago we saw many novice investors get crushed in their TVIX holdings. Below is a good summary, by a non banker, explaining in plain english about some of the risks associated with ETFs. Don’t forget, 80% of the issued ETFs, are done by 6 players. Most of those had to be bailed out by the taxpayers. Those are some risks to think about….From Golem.
Where will the next point of instability be? Not what will trigger the next liquidity and credit crunch and cause the next landslide of panic selling and losses. We can already see many candidates for the trigger. But what will be the mechanism by which it is amplified and spread?
I think that in a couple of years, unless something alters the current trends in money flows, we will come to know ETFs the way we already know the securitization and packaging of sub-prime mortgages into CDOs. I think the signs are already there to suggest ETFs are where the instability and risk is accumulating. If I am in any way correct then ETFs will be to the next stage in our on-going state of siege-mentality crisis what CDOs were to the last.
To substantiate this claim I have to tell you in simplified terms what an ETF is. And then explain how, despite all the differences between mortgage backed CDOs and ETFs, the latter generally being based on stocks, bonds and commodities rather than mortgages, they are undergoing the same evolution from simple to opaque, stable to unstable, are being seen as the provider of liquidity and risk-controlled ‘exposure to risk’, just as CDOs were, when in fact they are concentrating risk and will, in a moment of panic, cause liquidity and lending to collapse.
Still the world’s biggest bond fund manager, Bill Gross, on “Delivering in a delevering world”.
- When interest rates cannot be dramatically lowered further or risk spreads significantly compressed, the momentum begins to shift, not necessarily suddenly, but gradually – yields moving mildly higher and spreads stabilizing or moving slightly wider.
- In such a mildly reflating world, unless you want to earn an inflation-adjusted return of minus 2%-3% as offered by Treasury bills, then you must take risk in some form.
- We favor high quality, shorter duration and inflation-protected bonds; dividend paying stocks with a preference for developing over developed markets; and inflation-sensitive, supply-constrained commodity products.
About six months ago, I only half in jest told Mohamed that my tombstone would read, “Bill Gross, RIP, He didn’t own ‘Treasuries’.” Now, of course, the days are getting longer and as they say in golf, it is better to be above – as opposed to below – the grass. And it is better as well, to be delivering alpha as opposed to delevering in the bond market or global economy. The best way to visualize successful delivering is to recognize that investors are locked up in a financially repressive environment that reduces future returns for all financial assets. Breaking out of that “jail” is what I call the Great Escape, and what I hope to explain in the next few pages.
Guest post by Gresham’s Law.
If you ever happen to acquire an inclination for being the subject of disrepute and ridicule I highly recommend endorsing the conceit alluded to in the title. Apparently this issue is ‘so obvious’ that even gold bugs and government officials can reach common ground via the contention that I’m deluded. My folly — if you will — is to maintain that dollar debasement can be bullish for the dollar vis-à-vis other currencies at present. Since this long-standing conviction of ours is once again being corroborated by price action in the currency markets I thought I’d attempt to convince you that I’m not completely crazy. Here I outline why dollar debasement is bullish for the dollar against other fiat currencies in this environment.
Guest post by Steen Jakobsen,
I have been wrestling with that latter question here in the first few days of 2012. What if we are wrong to presume that the perfect storm coming? Have we overlooked something in our analysis, some significant driver that will continue to drive markets higher for a time?
The WSJ ran a “reminder” article yesterday on what the world’s biggest hedge fund, Bridgewater, and it’s boss, Dalio think about the Economy. Nothing new from Dalio, who is still very bearish on the debt, leverage, economy etc. We would like to remind our readers of a great piece on Dalio and his fund, by The New Yorker last year.
Dalio is a “macro” investor, which means that he bets mainly on economic trends, such as changes in exchange rates, inflation, and G.D.P. growth. In search of profitable opportunities, Bridgewater buys and sells more than a hundred different financial instruments around the world—from Japanese bonds to copper futures traded in London to Brazilian currency contracts—which explains why it keeps a close eye on Greece. In 2007, Dalio predicted that the housing-and-lending boom would end badly. Later that year, he warned the Bush Administration that many of the world’s largest banks were on the verge of insolvency. In 2008, a disastrous year for many of Bridgewater’s rivals, the firm’s flagship Pure Alpha fund rose in value by nine and a half per cent after accounting for fees. Last year, the Pure Alpha fund rose forty-five per cent, the highest return of any big hedge fund. This year, it is again doing very well.
And the conclusion;
Summing up the year for geared ETF holders might be quite the opposite of what they thought, despite being right. This is what they tell you;
Each Short or Ultra ProShares ETF seeks a return that is either 3x, 2x, -1x, -2x or -3x of the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily.
And this is what they don’t tell you, click here.