Stock Falloff Uncovers ETF Flaws
By ELEANOR LAISE
In the upheaval of the past several weeks, many of the things that can go wrong with exchange-traded products did go wrong.
Exchange-traded funds and exchange-traded notes generally offer cheap and easy access to parts of the market that might be otherwise inaccessible to small investors. But they also come with potential pitfalls.
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ETFs, for example, don't always precisely track their benchmark indexes and ETNs come with some risk that the issuer of these notes could default.
Such risks have been on display recently as everything from regulatory changes to bond-market turmoil posed challenges to the products.
An ETF resembles a traditional mutual fund and an ETN is a type of debt security, but both products trade on an exchange like a stock.
Bitten by Shorting Ban
The Securities and Exchange Commission's temporary ban on short sales of financial stocks caused troubles for the Short Financials ProShares (SEF), UltraShort Financials ProShares (SKF) and Rydex Inverse 2x S&P Select Sector Financial (RFN) ETFs, three funds designed to benefit when financial shares fall.
The ban, which took effect Sept. 19, is scheduled to expire this week following the enactment of the financial-rescue legislation.
In a short sale, an investor typically borrows shares and sells them, hoping to buy them back later at a lower price. Rather than shorting stocks themselves, the Rydex and ProShares funds typically buy complex financial contracts that allow them to make bets against financial stocks. The firms offering these instruments generally short financial shares.
But the short-selling ban raised questions about the ETFs' ability to obtain these instruments, and the ETF providers decided to temporarily halt creation of new shares for these funds.
Effect on Existing Shares
Those moves also affected existing shares of the ETFs: When there's no fresh supply of ETF shares to meet any increased demand, the fund may trade at a price well above the value of its underlying holdings.
On Sept. 19, for example, the UltraShort Financials ProShares closed at a market price 16% above the value of its holdings, according to research firm Morningstar.
Such a premium benefits someone selling those shares but hurts a buyer. A big selling point for ETFs has been that they generally trade very close to the value of their underlying holdings.
The short-selling ban can also affect ETFs that make bets against the broad market, causing them to trade at slight premiums or discounts to the value of underlying holdings, says Paul Mazzilli, ETF analyst at Morgan Stanley. For example, some ETFs are designed to benefit when the Standard & Poor's 500-stock index falls, and financials account for roughly 15% of that index.
Bond-Market Blues
Meanwhile, extreme uncertainty in the fixed-income market has caused bond prices to behave erratically and made trouble for bond ETFs.
The (HYG), for example, hit a closing price more than 8% below the value of its holdings on Sept. 17, according to Morningstar, while the closing price of PowerShares High Yield Corporate Bond (PHB) was 5.5% below the value of its holdings.
ETN Uncertainty
Recent events have also highlighted the credit risk involved with ETNs. Unlike ETFs and other funds, ETNs don't give investors ownership in a portfolio of securities. Rather, these notes are unsecured debt of the issuer, which typically promises to deliver a return tied to the performance of a market benchmark.
Lehman Brothers Holdings, which offers a family of three ETNs, filed for bankruptcy protection three weeks ago. Now, investors in those notes are "just in line with other unsecured creditors," says Scott Burns, director of ETF analysis at Morningstar. Given that trading in the ETNs had sunk to virtually nothing before Lehman's bankruptcy, however, it's doubtful small investors were seriously hurt, Mr. Burns says.
"It's always important for investors to know what they're really buying," Mr. Burns adds.
In many exchange-traded products, he says, "it's a benefit that you get access to hard-to-reach asset classes, but the cost of that is you have to take on incremental risk to do it." |
