How Safe Are Your ETFs?

October 10, 2008

The credit crisis is squeezing exchange-traded products. Here's an analysis of what's safe and what appears to be less so in differing categories.


The swirling financial crisis has investors questioning the safety of all types of investments, from bank accounts to CDs, money market funds and more.

Nothing seems safe. Even exchange-traded products.

The failure of the Lehman Opta exchange-traded notes in September awakened many to the credit risks inherent in the ETN structure. Now, the expanding credit crisis has many looking at the fine print of traditional exchange-traded funds, too.

Reviewing Stock ETFs

In general, the money invested in traditional stock exchange-traded funds appears safe from rampaging credit markets. Not safe from market movements, of course, but safe from the kind of credit risks that killed the Lehman ETNs.

As with mutual funds, when you purchase a traditional equity ETF, you purchase a pro rata stake in the holdings of the fund itself. For instance, when you buy the S&P 500 SPDR (AMEX: SPY) or the iShares S&P 500 Index Fund (NYSEArca: IVV), you are effectively buying a tiny piece of each of the 500 stocks held by those funds. That compares with an ETN, where all you are buying is a debt note from the underwriting bank.

There are risks to ETFs, however.

Many mutual funds and ETFs participate in the share-lending market, where they lend shares of their underlying stocks to investors who want to short a particular company. The short-seller will typically give the fund company cash as collateral, which the fund company then invests in short-term fixed-income instruments to make a little extra money.

This excess return sometimes is paid wholly to the ETF shareholders and sometimes is split between the shareholders and the ETF manager. It tends to vary by fund company, and many complexes refuse to disclose the split publicly.

Recently, failures in short-term commercial paper markets have caused some banks to lose money in their share-lending departments. So far, none of these losses has occurred at ETF providers, but there is some risk of losses on the margins if the credit crunch expands.

There is also a lack of transparency on what the fund companies receive as collateral in share-lending agreements. It is usually cash or short-term Treasuries, but there is no hard-and-fast rule, and very limited disclosure. The risk of a problem is very small, but many have called for increased disclosure of share-lending requirements.

It's worth noting in such an environment that there is a type of equity ETF that avoids this risk: the unit investment trust (UIT). This is a structure employed primarily by the earliest generation of ETFs, such as the aforementioned SPY, the Dow Jones Industrials Diamonds (AMEX: DIA) and the MidCap SPDRs (AMEX: MDY).

Unlike other ETFs, which are technically open-end funds, UITs are restricted from share lending altogether. They have their drawbacks—they cannot reinvest dividends, and as such, have a small cash drag compared with open-end funds and tend to underperform those funds slightly over the long haul. However, UITs may be the safest equity structures of all at the moment.

In general, the risk from share lending is small, but for the ultracautious, it may be worth considering.

Leveraged & Inverse Funds

The leveraged and inverse ETFs offered by ProShares and Rydex come with different kinds of risk.

The ProShares inverse funds, for instance, have historically relied on swaps to achieve market exposure. Swaps are privately negotiated contracts between two parties. The parties agree to exchange money based on the return of a given index.

For an inverse ETF tied to the S&P 500, for instance, ProShares might agree to give the counterparty cash if the index goes up, and the bank will agree to give ProShares cash if the index goes down. The risk is that these are privately negotiated contracts.  If the counterparty in a swap goes bankrupt, the ETF company is exposed.

In fact, we saw this play out in a small way earlier this year when Lehman Brothers went bankrupt. ProShares likely had a few swaps in place with Lehman at the time. The company issued a statement following the bankruptcy saying that its exposure to Lehman was minimal; it also said it would make the ETFs whole if they suffered any losses as a result of Lehman's troubles.

Among other things, such action showed that ProShares monitors its counterparty risk closely, and in this case, agreed to indemnify shareholders. Still, it also revealed that some risk exists in the swaps market.

Note, however, that the size of this risk is limited. This is a commonly misunderstood point.

In a swap contract, the two parties do not exchange the principal of the investment; it is not as if ProShares or Rydex gives the counterparty all of the value of the swap to hold as collateral.

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