Defending The “Most Dangerous ETFs”

by on September 25, 2009 | ETFs Mentioned:

Don Dion, who covers ETFs for and runs Dion Money Management, recently wrote a three part series highlighting the “10 Most Dangerous ETFs”. Dion notes that as the ETF industry continues to expand beyond “plain vanilla” funds, investors are introduced to products that can face significant liquidity issues, be subject to increased regulatory scrutiny, and carry “unprecedented risks” associated with their complex and non-traditional strategies. While I agree with most of Dion’s analysis (and certainly share his view that there are a number of complex ETFs that should be limited to the most sophisticated investors), I feel it’s necessary to defend a few of the ETFs that made the list: 

Claymore/BNY Mellon Frontier Markets (FRN)

Parinacota Volcano in ChileFRN invests in frontier markets, which generally refer to the least developed economies in the world. MSCI Barra, a provider of domestic and international equity indexes, analyzes 75 markets around the world on four market accessibility criteria, including: (1) openness to foreign ownership, (2) ease of capital inflows/outflows, (3) efficiency of the operational framework, and (4) stability of the institutional framework. Based on their performance in these areas, each market is slotted into one of three categories: developed, emerging, or frontier.

Dion notes that frontier markets, which include Chile, Poland, Egypt, Colombia, and Kazakhstan, are “the most emerging of emerging markets” and are volatile both economically and politically. There’s no doubt that frontier markets are extremely risky. But they also offer tremendous reward potential. Frontier markets often offer potential for greater payouts due to the presence of numerous inefficiencies in asset pricing and flow of information. They can also see rapid expansion if market reforms and strengthened investor protection attract foreign investment.

“Frontier markets are where emerging markets were, in some cases, 10 to 20 years ago,” says Antoine Van Agtmael, the chief investment officer of Emerging Markets Investors who is credited with inventing the term “emerging markets” in the 1980s in a Barron’s article earlier this year. Twenty years ago, China, Brazil, and India would likely have fit into this same category – facing extreme volatility and uncertainty and lacking clearly developed markets. I doubt that any investor who has maintained diversified exposure to these economies over the last two decades has been disappointed with the results.

We looked at the volatility of FRN’s daily returns compared to SPY (which tracks the S&P 500) over the last 15 months, and found surprisingly little difference. Moreover, FRN is up nearly 50% in 2009, while SPY has gained only about 16%.

iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) and Short-Term Futures ETN (VXX)

I would venture to guess that most of the interest in these ETNs is speculative in nature. While VXZ and VXX are excellent tools for speculating in market volatility, these products can also be used as strategic diversifiers in equity-intensive portfolios. During the recent recession, many analysts noted that diversification across many asset classes and geographies let investors down when they needed it most. Correlations of most investments headed towards 1, essentially eliminating any theoretical diversification benefits in portfolios. Since their inception, VXX and VXZ have maintained strong negative correlations with both U.S. and global equities, making them valuable tools for investors looking to implement a small hedge in their portfolio.

Banknotes From Around The World At The British Museum In LondonPowerShares DB G10 Currency Harvest Fund (DBV)

This fund aims to profit from movements in exchange rates, taking long positions in the three G10 currencies with the highest interest rate and short positions in the three G10 currencies with the lowest interest rates. Generally, currencies with high interest rates tend to appreciate relative to those with low rates, and this product seeks to exploit that trend. Dion points out that in times of economic turmoil, these trends may reverse, quickly eliminating gains that were accumulated over longer periods of time. He goes on to note that if the dollar rebounds, DBV could get flattened.

However, PowerShares notes that if the U.S. dollar is one of the six currencies associated with the highest or lowest interest rate, the fund won’t establish a long or short futures position in the greenback. Because the dollar is the fund’s home currency, it “cannot profit or suffer loss from long or short futures positions in USD.”

Currency investing is risky business to start with, and the use short positions in this fund’s strategy only adds complexity. But for investors who are looking for an efficient way to play the carry trade, DBV is an excellent option. Rather than establishing six separate positions through futures markets, investors can purchase a single security.

The rise of the ETF industry has democratized investment strategies, including the currency carry trade, that were previously available only to large institutions. For investors with the stomach for the risk that comes with any forex investment, DBV can be a great product.

Direxion Daily Financial Bull 3x Shares (FAS) and Daily Financial Bear 3x Shares (FAZ)

By now, everyone has heard about the intended uses and common abuses of leveraged ETFs (see our Complete Guide to Leveraged ETFs for more details). In periods of high volatility (such as the one recently endured by the financial sector), these leveraged funds may see dramatic declines in share prices if held for multiple trading sessions, regardless of the direction of the markets.

But most people don’t hold FAS and FAZ for multiple trading sessions. FAZ has about 58 million shares outstanding, and has had daily volumes between 50 million and 109 million shares over the last month, implying average holding periods of less than a day for these securities.

The real question is: how well do these ETFs accomplish their stated objective? We did a quick download of daily returns for FAS and FAZ since November 2008 (about 220 trading days) to get an answer to this question. Over this period, FAS generated daily returns that were between 250% and 350% of the daily return on the Russell 1000 Financial Services Index nearly two-thirds of the time. When we expand the corridor to 200% to 400%, this figure rises above 80%. FAZ had even better results, delivering daily returns between -250% and -350% of the Russell 1000 Financial Services Index 69% of the time. FAZ was between -200% and -400% almost 85% of the time.

Daily Returns of Russell 1000 Financials Index Return FAS FAZ
Frequency Between 250% and 350% (FAS) or -250% to -350% (FAZ) 63% 69%
Frequency Between 200% and 400% (FAS) or -200% to -400% (FAZ) 82% 84%

Oil PumpPowerShares DB Crude Oil Double Short ETN (DTO)

DTO offers inverse leveraged exposure to oil prices, which Dion notes leaves double the exposure to regulatory changes. In coming months, the CFTC is expected to implement position limits on commodity futures, while FINRA is expected to increase margin requirements on leveraged ETFs beginning December 1. One PowerShares DB fund (DXO) has already shut down due to the new regulatory changes,and Dion wonders if DTO will be next.

A couple points here. First, while DTO does indeed offer leveraged exposure to oil prices through the use of derivatives, it’s very different from the leveraged products offered by Direxion and ProShares. DTO resets on a monthly basis (as opposed to daily), meaning that the “decay problems” in volatile markets won’t be nearly as pronounced with this fund. Note that PowerShares / Deutsche Bank haven’t been targeted by FINRA or the Massachusetts Secretary of the Commonwealth in their investigations into the marketing of leveraged products because funds like DTO are very different from daily leveraged funds.

Second, DTO is a relatively small fund, with a total market capitalization of about $135 million. While predicting the exact position limits that will be put in place is impossible, it seems unlikely that DTO would trip these limits (see Matt Hougan’s take on exactly what doomed DXO for a more thorough discussion on this topic). UNG (which also made the Most Dangerous list) has run into problems because its market cap has swelled above $4 billion, and the fund has been rumored to hold as much as 80% of open interest in NYMEX front-month contracts. DTO isn’t nearly the size of UNG, so the likelihood of tripping regulatory requirements and closing its doors is significantly lower.

Disclosure: No positions at time of writing.