Peregrine's Fall A Boon To Futures ETFs
July 18, 2012
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The quick demise of fraud-ridden futures broker Peregrine Financial less than a year after MF Global filed for bankruptcy in a scandal involving misallocated assets has definitely dented investor confidence in the futures industry, but it’s unlikely to hurt the still-growing demand for futures-based ETFs.
Quite the contrary, in fact. As Teucrium’s Chief Executive Officer Sal Gilbertie put it, the futures brokerage industry is clearly having some problems, but the futures markets are not broken.
As jaded investors look for ways to protect themselves from what can seem like a never-ending stream of brokerage shenanigans, they remain largely undeterred in their pursuit of broad diversification, which is rapidly coming to include relatively new “asset classes” such as commodities and currencies.
Gaining exposure to currencies and commodities is often achieved through futures, and futures-based ETFs—which enjoy an extra layer of regulatory oversight that didn’t exist for firms like Peregrine—have an opportunity to emerge as a viable alternative to futures investing done through possibly shady Peregrine-like firms.
Futures-based ETFs have already been growing in popularity thanks to an expanding roster of strategies that serves up exposure to everything from gold to oil to corn. Altogether, they hold more than $106 billion in assets and represent nearly 10 percent of total U.S. ETF assets today.
“The need for these products is not going to go away,” Sam Masucci, chief executive officer of Gencap, the new ETF firm that plans to help others bring ETFs to market—including futures-based strategies—said in a recent interview.
“Anyone interested in having a properly diversified portfolio must have a component in commodities, especially if you’re concerned about things like non-correlated assets, inflation and real-returning assets. You can only get that from commodities and real estate,” he said.
The Common Thread
Peregrine, MF Global and Refco all served as what Gilbertie called “second-tier” futures commission merchants, or FCMs. A second-tier FCM is one that’s a smaller brokerage firm, often privately held, but, more importantly, one that is not as regulated or supervised by any government agency as a publicly-held one is.
These FCMs typically manage a lot of the assets invested in futures for people who either need exposure to futures as speculators who are looking to profit—“locals” in futures parlance—or for those such as farmers or oil companies who need to take delivery of the underlying commodity when a given futures contract expires.
But what they also had in common was that none of them had a big bank to back them up, United States Commodity Funds’ Chief Investment Officer John Hyland said in an interview.
When their troubles came to light, there were no deep pockets to bail them out, something that Hyland argued is a key protective measure investors should insist is in place before they invest in futures.
“We (USCF) really do not look at doing business with firms that are independent stand-alone companies,” Hyland said. “There are other steps you can take to protect yourself from credit exposure to your FCM, like minimizing margin being held, not posting cash, and having back-up accounts at other firms. Watch them like a hawk.”
But in the end, Hyland added, “making sure they have somebody ‘upstairs’ to lend them a quick $500 million when needed,” is crucial.
“Of course Refco and Peregrine had major elements of fraud in their downfall, while MF Global seems more a case of bad business model and excess leverage. But in all those cases a large bank parent would have made a huge difference,” Hyland said.