Sunday, March 16th, 2008...10:25 am
Ultra ETFs and Counterparty Risk
In a few previous posts, I mentioned using leveraged ETFs as an investment tool. If you own any shares of ProShares, ProFunds or Rydex leveraged funds, keep reading. The rest of you are free to go recess early today.
This weekend I read the prospectus for all three companies providing leveraged ETFs. A leveraged ETF is a stock ticker that matches some index in a leveraged relationship. For example, I own the ticker SKF, which is double the inverse of the Dow Jones Financial Index. As financial companies decline in value, my ETF goes up in value at double the rate. In addition to the normal risks associated with investing, these shares also have something called counterparty risk. In order to achieve this leverage the companies engage in derivative trading. As long as the parties engaged in the trading are financially healthy, there is no counterparty risk.
From the ProShares prospectus:
If a counterparty becomes bankrupt or otherwise fails to perform its obligations due to financial difficulties, the value of your investment in a Fund may decline. A Fund may experience significant delays in obtaining any recovery in a bankruptcy or other reorganization proceeding and a Fund may obtain only limited recovery or may obtain no recovery in such circumstances. The Funds typically enter into transactions with counterparties whose credit rating is investment grade, as determined by a nationally recognized statistical rating organization, or, if unrated, judged by Proshare Advisors to be of comparable quality.
There is a sentence up there that makes me nervous.
The Funds typically enter into transactions with counterparties whose credit rating is investment grade, as determined by a nationally recognized statistical rating organization…
Any reader of Calculated Risk or Mish’s Global Economic Trend Analysis is already aware of the hijinks being played by the ratings agencies. Credit ratings are becoming increasing less trusted. It is possible that the unnamed counterparties behind the leveraged ETFs have toxic balance sheets and the ratings agencies are looking the other way, hoping the problem resolves itself.
How does one measure this risk? I haven’t figured out a way. My research tells me the chances are very remote. However, having read When Genius Failed, which was an accounting of the 1998 LTCM crisis and watching the Bear Stearns disaster unfold, tells me the risk does exist. And if it happens, there will be no time to get out.
There is a way to play the Ultra ETFs that avoids counterparty risks. It involves either buying options or shorting the opposite ETF (ex: short the Ultra Long if you are bearish, short the Ultra Short if you are bullish). However this is usually not permitted in IRA accounts.
My strategy for next week is to start exiting my ProShares ETFs and move investment money to managed bear funds that aren’t exposed to counterparty risk. Prudent Bear (BEARX) and Grizzly Short (GRZZX) are two that I’ve discovered. Prudent seems to do better in a bull market and Grizzly does better in a bear market.
Tags: etfs
10 Comments
March 16th, 2008 at 11:00 am
Nice writing. You are on my RSS reader now so I can read more from you down the road.
Allen Taylor
March 17th, 2008 at 12:10 pm
I was pondering this very question this weekend. It seems to me that the final act of owning the SKFs of the world is knowing counterparty risk is the primary risk and selling before the federal government or the Federal Reserve sanction the stiffing of “winners” in UltraShort vehicles. Pick a reason: security, stability, both.
March 17th, 2008 at 12:12 pm
I sold my SKF this morning. Locked in a 60% gain. It’s tough to walk away from the table when you are ahead.
March 20th, 2008 at 2:40 am
How do you know there is no counterparty risk in BEARX and GRZZX?
Does it make sense to short the UltraLongs? If there is counterparty loss do you gain that also (since you are short)?
Great post …thanks!
March 20th, 2008 at 8:09 am
Jim,
I read the prospectus for BEARX and GRZZX. I saw no mention of counterparty risk. They are engaging in more direct shorting.
Shorting the UltraLongs is the safer way, however many IRA investors do not have this option available to them.
March 21st, 2008 at 9:27 am
Great post. I’ve had this niggling feeling about the ultra ETFs for some time, since everyone is piling into them, that something could blow up there as well. I’ve also been using them to hedge my RRSP (i.e. IRA) account. The grand explosion of ETFs and ETNs is likely to come to an abrupt halt at some point.
I’ve also noticed that some ETFs have started to diverge in a not insignificant fashion from the underlying. I would not be at all surprised if the smart money is starting to put on positions with a bet that some of these will eventually fail.
I’ll put you on my reading list as you’ve obviously got some great ideas (quicker than the ticker).
March 21st, 2008 at 2:46 pm
Are puts safe from counterparty risk? Who’s on the other side of the trade, “the market”? Somewhere you and everyone else who’s long puts are balanced by those on the short side of the trade. If a big one goes down, such that there’s not enough money to make good all the puts, what happens? Even if you transacted with a market maker who’s running a net netural book, he too could fail if the short side isn’t covered - then what?
Being short actual shares, the other side is long the shares and subject to the usual 50% margin requirements, plus you get his money right away don’t you? If he goes down he’ll likely be forced to fire-sell his assets which may actually help your short position. Of course, you have unlimited loss potential if the trade goes against you, and you are also subject to a squeeze if shares available to borrow dry up. Nothing in life comes for free…
March 21st, 2008 at 3:34 pm
From everything I’ve read, Puts are safe from counterparty risk. I’m not an expert on options, so seek out an expert on this topic.
March 22nd, 2008 at 12:12 am
Why not just buy gold. Now there is an asset with zero counterparty risk. No! Not GLD.
March 26th, 2008 at 5:24 pm
Puts - I agree with MAS …everything I’ve read says puts have no counterparty risk. Don’t know why though.
Gold - Pure gold may not have counterparty risk, but you may be buying at the top of the market. Gold is often an inflation hedge …if we get a seriously nasty recession (with a credit crunch and falling housing prices) we could end up in a deflationary scenario (everything gets cheaper). In this case cash is king.
Anyway, just my 2 cents. Thanks for the great entry MAS …I sold off all Ultra Shorts last week and now own GRZZX (in IRAs) and Puts/Shorts in my cash account. I shorted Ultra Longs when they were available… I’m thinking this could generate a “counterparty dividend.”
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