They lurk in the dark shadows of the ETF trading jungle, stumbling aimlessly in no particular direction, never really going anywhere. They lie in wait for an investor’s wallet.
We’re talking about “zombies,” a quasi-classification of exchange-traded products that can lead investors into a bad—and costly—illiquid trading experience. Beset with a lack of assets under management, no trading volume and no compelling investment case, they can be found in all asset classes and structures. (See: What Is An ETF? and What Is An ETN?)
Inevitably, some investors will walk naively into these funds and walk out financially bruised from trading costs. With the rise of the Robinhood trader and surging retail demand, it’s easy to see how a simple Google search could send someone into Zombieland.
Why they exist is anyone’s guess. Maybe there’s a way to make money with only $1 million in assets and a 0.75% expense ratio, or maybe they need to be culled from the ETF market for the sake of investor interests.
Red Flags In Trading Spreads
One of the biggest telltales you may be faced with regarding a “zombie” fund is trading spreads. On our most recent hunt for zombies in the land of U.S.-listed ETFs, we came across a handful of ETNs that exhibit all the red flags that signal “zombie.”
|Ticker||Fund||Launch Date||AUM||Daily Share Vol. (45 day avg)||Avg Spread (45-Day)||Expense Ratio|
|TAPR||Barclays Inverse U.S. Treasury Composite ETN||14/7/2014||$3M||24||74.44%||0.78%|
|EEH||Elements Spectrum Large Cap US Sector Momentum Index ETN||1/8/2007||$1M||336||8.50%||0.75%|
|FUE||Elements MLCX Biofuels Index-Total Return ETN||5/2/2008||$426K||594||13.17%||0.75%|
|FLAT||iPath U.S. Treasury Flattener ETN||9/8/2010||$4.8M||71||6.57%||0.75%|
|DTUS||iPath US Treasury 2-Year Bear ETN||19/8/2010||$1.5M||185||8.36%||0.75%|
ETNs are different from ETFs. They are debt notes issued by a bank. When you buy an ETN, the bank promises to pay you a certain pattern of return. If you buy an ETN linked to the price of gold, for instance, the value of that ETN will increase if the price of gold goes up.
The downside of an ETN is that if the underlying bank goes bankrupt, you lose essentially all of your money. This credit risk in most situations is minor, but it’s a risk nonetheless.
TAPR Tantrum Trading
Take for example the Barclays Inverse U.S. Treasury Composite ETN (TAPR). TAPR has a miniscule 45-day average daily volume of only 24 shares. It has scant assets under management and an eye-jolting 60-day average spread of 74.44%. It’s also expensive, with a 0.75% price tag.
TAPR was last trading with a smaller (but still huge) trading spread of 24%. With a bid of $78.61 and an ask of $100, unwitting investors could end up buying 25% above the current net asset value and selling more than 2% below the NAV (based on current bid/ask prices).
In situations like these, knowledge of the underlying NAV and using limit orders, not market orders, is crucial. If you aren't cautious and use market orders, you can get killed by buying at that high ask and selling at the low bid, which does happen.
TAPR is not for the novice investor. The index equal-weights short positions in a variety of U.S. Treasury futures contracts: two-year, five-year, 10-year, long-bond and ultra-long. The note will appreciate in value if prices of Treasuries fall (and rates rise) across the yield curve, according to FactSet. That rarely happens.
Zombie Peas From The Same Pod
The next four “zombies” come in two pairs from different pods.
The first pair comes from the Elements brand, and the issuer Swedish Export Credit, which carries the credit risk for both, and is considered by FactSet to be a low-default risk. But trading these two is a high-risk move.
The Elements MLCX Biofuels Index-Total Return ETN (FUE) tracks an index of seven biofuel-related commodities weighted by their calorific potential. It gains exposure through second- and third-month futures contracts.
FUE has clearly not caught on after stumbling through the ETF ecosystem since 2008. It has only $426,000 in assets, and trades with an average spread of 13.56%. FUE is also pricey, with a 0.75% expense ratio, which could cost an investor more than 14% of their investment just walking in the door.
Market Orders Will Haunt You
The risk for investors here comes from the new traders and the retail crowd. Someone who wants to invest in biofuels, say, over crude oil, could find the fund on a Google search looking for “biofuel” securities.
Like FUE, the Elements Spectrum Large Cap US Sector Momentum Index ETN (EEH) has found a similar fate. This ETN, which tracks an index of large cap U.S. stocks aiming to outperform the S&P 500 through a momentum strategy, has languished, with $1 million in AUM. With average daily share volume of 336 shares, the average trading spread comes in at 8.50%. That’s a monster considering the world’s most liquid and traded ETF, the SPDR S&P 500 ETF Trust (SPY), trades at 0.01%.
What’s amazing about EEH and FUE is how long they’ve lasted, nearly 12 years.
The iPath U.S. Treasury Flattener ETN (FLAT) and the iPath US Treasury 2-Year Bear ETN (DTUS) have been largely overlooked by the trading crowd. FLAT trades a daily average of 71 shares and carries an average trading spread of 6.57%.
FLAT provides inverse exposure to an index that's designed to increase when the yield spreads between two-year and 10-year Treasuries widen. As such, FLAT appreciates only when yield spreads narrow.
DTUS takes the cake for having the most opaque thesis of the five ETNs here.
DTUS provides inverse exposure to the Barclays 2Y US Treasury Futures Targeted Exposure Index. The index increases when yield decreases, and the inverse note gains 10 cents for each 1-point drop in the index. The “Bear” in the note’s name indicates direction—that it rises when yields rise, unlike a bond, according to FactSet.
It comes in with a higher spread than FLAT, at 8.36%, despite having more daily average shares traded of 185. But, again, the risk is buying in and spending nearly 10% of your investment just to get in the door.
There Is Help
Knowing the average daily trading volume, trading spreads, expense ratios and using limit orders, if you’re so inclined, to jump into an illiquid security will help you at least make an educated decision.
There are many ETFs and ETNs that fall into this “zombie” or “approaching zombie” status, and the signs are usually very clear. Simple due diligence is your best weapon.
Drew Voros can be reached at [email protected]