Should You Trust Your ETF?
July 18, 2012
With all the sleaziness on Wall Street these days, it's no wonder ETF investors are wondering if they're safe.
Rate-fixing. Fraud. Money-laundering. Today’s hottest growth niche seems to be white-collar crime by financial institutions. Can you trust your ETF to steer clear of these shenanigans?
Here’s a look at the parts of the ETF world that rely on trust—starting with those most frequently misunderstood—and their impact on risk to ETF owners.
ETF Short Sales
ETFs trade like stocks, not like mutual funds. This means ETFs can be shorted—borrowed, sold and repaid in kind—by those betting on a drop in price.
Short positions in certain ETFs can reach high levels, and for a handful of funds, will occasionally exceed the total amount of ETF shares outstanding. This apparent impossibility typically results from serial short-selling, where A lends shares to B, and—rather than selling the shares—lends them to C.
The bottom line here is that those who hold the ETF shares—and more importantly, the fund itself—bear extremely little risk from short-selling. Only those who hold the shares have any claim on fund assets, so massive shorts won’t lead the fund to ruin.
The typical ETF holds a basket of stocks. Shareholders hold a proportional claim on that basket. But many issuers loan out these stocks and receive interest in return. This sounds risky and maybe a little bit fishy, too. (To be clear, this topic differs from short sales of ETF shares by market participants.)
The risk to the ETF shareholders associated with securities lending is quite small. Fund managers demand collateral when lending the stocks—typically extremely liquid and safe securities, such as Treasury bills.
This is not a margin account: ETF managers require the full value of the stocks they lend, plus a little more, typically described in the prospectus as 102 percent of the stocks’ value.
Most ETFs don’t hold derivatives. They hold baskets of actual stocks and bonds instead. But certain assets, like some commodities for example, are accessed by ETFs using derivatives. And even in plain-vanilla funds, the prospectus language may permit derivative use.
When ETFs do hold derivatives, the risk comes in two flavors: low and lower. This may sound odd, but it’s true.
The first variety includes derivative contracts between two parties, such as a swap agreement to deliver a particular pattern of returns.
The risk here is that the other side won’t pay what they owe. But counterparty risk here is low because each side starts out owing the other nothing, and, at regular intervals, the account gets trued up.
So if a counterparty blows up, the ETF’s likely exposure is only the performance gains over a short period—maybe a few weeks. Nothing else is at risk.
The second flavor of risk comes from listed derivatives—those that trade on an exchange, rather than over the counter. Here the counterparty risk is even lower, and would require the exchange itself to fail.