Ultra ETFs and Counterparty Risk

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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.

15 thoughts on “Ultra ETFs and Counterparty Risk

  1. Allen Taylor

    Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

  2. martymar

    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.

  3. Jim Hancock

    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!

  4. 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.

  5. GKM

    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).

  6. Doug

    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…

  7. 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.

  8. Jim Hancock

    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.” 🙂

  9. I have a financial advisor who is pretty sure we are about to have a crash.

    He recommended I stock up on (Dog) an inverse ETF.

    I bought 10 call contracts in the money. It is just holding its own as of now.

    I also bought 4 call contracts of SKF in the money (these I picked myself.

    I would like someone to tell me if I am a fool and about to lose a ton of money.

    On a good day, I lose a bundle, and on abad day I get it back.

    Morry J

  10. Morry,
    Nobody knows for certain. I think history is on your side though. Profit estimates are still too high for the indexes. Just take your profits when you can. Don’t get greedy at the bottom.

    MAS

  11. Woody

    Glad to have found this discussion. I checked out of SKF & QID this a.m. because I was afraid of counterparty risk. Hard to leave when you’re making money, but would rather live to fight another day. Called Proshares and they won’t talk about who they have agreements with, though they did post a note on their website that they have no agreements with AIG or Lehman. Will be looking into bear funds, but GLD doesn’t sound too bad as the market gets into panic selling…

  12. brian

    ok so I have a stupid question. What happens to these ultras when they start to approach zero? Do they just take small penny steps downward and sort of freeze up since they will not truly be able to match the percentage properly or do they split them if it becomes a problem? Has it happened where it was a problem? thx

  13. Brian –
    Hopefully they thought about that and set it up. But these are new investment tools. The DCR ticker blew up this summer, because they didn’t think oil could ever go to $140 a barrel.

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