Leveraged ETF’s Running Away From The Spotlight

By: Pete
Date posted: 04.02.2012 (12:39 am) | Write a Comment  (0 Comments)

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You might have heard about the entire TVIX fiasco. If not, I could recommend many different good readings but here is the short story. Leveraged and structured ETF’s and ETN’s have different characteristics and for that reason, some rare events can sometimes occur in those ETF’s. One important thing to understand about ETF’s is that the basic premise of the efficiency of the ETF markets mostly on one critical element:

-Having select market participants that ensure the ETF trades close to its actual value (NAV-Net Asset Value) at all times

How Do They Get It Done?

It’s quite simple. These market makers or arbitrageurs, buy or sell the ETF each time it moves away from its actual value. For most ETF’s, if it gets anywhere outside of it of 1 penny, arbitrage is made and the ETF gets back in line. There are some exceptions though. Generally, those are caused by ETF’s that are difficult to hedge. For example, an ETF that tracks high yield bonds is much more difficult to hedge than one that tracks the 30 stocks from the Dow Jones Index. This can cause the price of an ETF to be a few cents away from the NAV at certain times.

An Extreme Example

What happened with TVIX was a much more tricky situation though because the fund decided to no longer accept new creation orders. What does this mean? If someone wants to arbitrage, he needs to be able to both buy and sell units at their actual value (NAV) from the ETF issuer. Once that is no longer possible, the arbitrage opportunity becomes impossible. How can someone sell an ETF that he can only buy back in the market (which might no longer be trading close to NAV)?

Exceptional Situation

The reason why a fund would stop subscriptions or redemption can vary and they are often very complex. The most important thing to remember though is that this would happen in leveraged/structure ETF’s, and once it does, it can create nightmares. What am I talking about? Look at how the ETF prices started to move away from what they were actually worth:

This means that when the ETF does actually move back to NAV (when fund subscriptions are resumed), some investors end up losing a lot of money.

The problem is that an event like this raises a lot of concerns from regulatory arms, not only for leveraged ETF’s but ETF’s in general. It’s CRITICAL to see the difference between the 2. I can’t imagine this happening to a standard ETF while it’s likely to happen a lot more with leverage ETF’s…

The Lesson

Like any other type of financial product, it’s important to look at what you are buying carefully. Not all ETF’s are alike and not all of them are suitable for longer term investments.

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