Hidden Credit Risks of ETFs

Friday September 19, 2:00 pm ET
By John Gabriel
Morningstar.com

Most exchange-traded products are index investments, backed by the actual portfolio of equities or bonds. Although an investor may be taking on the underlying risks of those portfolio holdings, they are not exposed to any risk from the issuer’s financial state. For example, if State Street (STT) were to go bankrupt (unlikely, even in these tumultuous times), investors in the SPDRs ETF (SPY) would be made whole by their claims on the underlying stock investments held by the unit trust.

However, not all exchange-traded products have this safety. Exchange-traded notes, or ETNs, are actually promissory notes with no claim on an underlying portfolio, so they are only as trustworthy as the debt of their backing bank. Morningstar’s director of ETF analysis, Scott Burns, recently wrote an article on ETNs and the credit risk that they face.

Besides ETNs’ inherent credit risk, some ETFs also posses a certain amount of credit risk. Some ETFs cannot invest directly in their underlying assets, relying on swaps, futures, or other derivatives to match the return on their index. These derivatives open those ETFs to counterparty risk, the risk that the institution on the other side of their trade will default, which could leave a fund with no return on its assets or even a loss. The ETFs vulnerable to counterparty risk fall into two major categories: leveraged funds and commodities funds.

Leveraged ETFs
ProShares and Rydex are the two biggest issuers of leveraged funds, which seek to provide some multiple of the return on an index or sector. Examples include UltraShort Financials ProShares (SKF), which seeks to provide twice the opposite of the daily return of the U.S. financials sector, and the Ultra S&P500 ProShares (SSO), which seeks to provide twice the daily return of the S&P 500 Index. These ETFs cannot invest directly in a basket of equities twice the size of their index or short-sell their entire portfolio due to restrictions on the investments allowed in a U.S. mutual fund structure, so they instead use swap derivatives to capture the desired daily leveraged returns. These index swaps are contracts traded through investment banks where one party offers to pay a fixed interest payment on a set date in the future in return for the other party offering to pay the return on an agreed-upon index such as the S&P 500. Leveraged ETFs keep the bulk of their assets in cash as collateral, then enter swap agreements based upon their asset values that replicate the desired multiple of an index’s return.

The bank that issues the swap contract frequently guarantees the payments and oversees posting of collateral by both parties, but that is little comfort when investment banks are collapsing. Also, if a major counterparty defaults, as American International Group (AIG) was threatening to earlier this week, the investment bank may not have enough capital to make the other parties whole and may be forced into default.

Although this seems like a lot of risk, there are mitigants. The first bit of good news is that, even if the swap contract is defaulted upon, the fund still holds all of its cash assets. The most a fund could lose is the return owed through a swap contract; it will never lose principal. The second bit of good news is that these swap contracts are very short-term, never written for more than 30-day periods. This gives leveraged ETFs some agility and allows them to quickly close out any exposure to investment banks that look to be edging toward bankruptcy.

We talked to representatives from both ProShares and Rydex and they indicated that their short-term contracts enabled them to minimize their funds’ exposure to the collapse of Lehman Brothers and could cover the tiny losses any funds might have sustained. Still, a very swift collapse of a major investment bank or hedge fund in the near future cannot be ruled out (even with recent government moves), and it would almost certainly cause these funds to lose some of their returns, although fortunately the principal would remain secure.

Commodities ETFs

Commodities ETFs also frequently use derivatives rather than directly investing in the underlying assets. This is because it would not be practical to take custody of millions of barrels of crude oil, tons of coal, or bushels of corn in an effort to match benchmark returns. In order to replicate their stated index returns, commodity-based funds invest in futures, forwards, and swap contracts without actually taking physical delivery.

One of the largest and best-known commodities ETFs is United States Oil Fund (USO). This fund–which is often used by institutions as an easily accessible hedging vehicle–is designed to track the movements of both light and sweet crude oil. Its portfolio consists primarily of listed crude oil futures contracts and other oil-related futures, forwards, and swaps, which are collateralized by cash, cash equivalents, and U.S. government obligations with remaining maturities of less than two years. There should be no concern here, as the fund’s exposure is collateralized on a dollar-for-dollar basis with extremely liquid assets.

However, digging further, we notice that a portion of the fund’s trades might be in over-the-counter contracts with investment banks, which are not as liquid as exchange-traded oil futures contracts, thus exposing the fund to credit risk associated with its counterparties. This exposure may have built up in the past, when forward contracts through investment banks were cheaper than exchange-traded contracts or could be based upon more obscure underlying assets. Although this type of counterparty risk may be present, we think commodities fund managers will seek to minimize their exposure to investment banks. They will likely sacrifice cost advantages for greater security by moving the portfolios fully into exchange-traded futures. Exchanges ensure each day that futures contracts are fully collateralized, and they require all counterparties to supply enough collateral that there is nearly zero risk of default. This rather pleasant option for commodities ETFs should help them avoid any troubles with counterparty defaults through this crisis, although it may reduce the profitability of the fund sponsors.

ETF Analyst Bradley Kay contributed to this article.

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2 Responses to Hidden Credit Risks of ETFs

  1. Lou Thomas says:

    FXE is one example of a fund that holds currency (in this case, Euros) in a bank account that pays interest. It seems to me that if the bank in which those funds are deposited were to become insolvent, then FXE could lose some of its deposited funds. So, while this seems to be a very safe ETF because it holds cash, if worse came to worst and big banks started tanking, it seems that even such an ETF could be more risky than, say, the bonds of a major government (e.g., Germany). Is that correct?

  2. Jason says:

    Hi Lou,

    Thanks for commenting. I believe you are correct. This fund, like so much other paper, is not an end of world hedge. I would hold real coins, including gold, for something to save you in a meltdown. From the FXE prospectus:

    The Deposit Accounts are not entitled to payment at any office of JPMorgan Chase Bank, N.A. located in the United States.

    The federal laws of the United States prohibit banks located in the United States from paying interest on unrestricted demand deposit accounts. Therefore, payments out of the Deposit Accounts will be payable only at the London branch of JPMorgan Chase Bank, N.A., located in England. The Trustee will not be entitled to demand payment of these accounts at any office of JPMorgan Chase Bank, N.A. that is located in the United States. JPMorgan Chase Bank, N.A. will not be required to repay the deposit if its London branch cannot repay the deposit due to an act of war, insurrection or civil strife or an action by a foreign government or instrumentality (whether de jure or de facto) in England.

    Shareholders do not have the protections associated with ownership of a demand deposit account insured in the United States by the Federal Deposit Insurance Corporation nor the full protection provided for bank deposits under English law.

    Neither the Shares nor the Deposit Accounts and the euro deposited in them are a deposit insured against loss by the FDIC or any other federal agency. Deposits may have only limited protection under the Financial Services Compensation Scheme of England.

    Euro deposited in the Deposit Accounts by an Authorized Participant are commingled with euro deposited by other Authorized Participants and are held by the Depository in either the primary deposit account or the secondary deposit account of the Trust. Euro held in the Deposit Accounts are not segregated from the Depository’s other assets. If the Depository becomes insolvent, then its assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant. In addition, in the event of the insolvency of the Depository or the U.S. bank of which it is a branch, there may be a delay and costs incurred in recovering the euro held in the Deposit Accounts.

    The Trust has no proprietary rights in or to any specific euro held by the Depository and will be an unsecured creditor of the Depository with respect to the euro held in the Deposit Accounts in the event of the insolvency of the Depository or the U.S. bank of which it is a branch. In the event the Depository or the U.S. bank of which it is a branch becomes insolvent, the Depository’s assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant for the amount of euro deposited by the Trust or the Authorized Participant, in such event, the Trust and any Authorized Participant will generally have no right in or to assets other than those of the Depository.

    In the case of insolvency of the Depository or JPMorgan Chase Bank, N.A., the U.S. bank of which the Depository is a branch, a liquidator may seek to freeze access to the euro held in all accounts by the Depository, including the Deposit Accounts. The Trust and the Authorized Participants could incur expenses and delays in connection with asserting their claims. These problems would be exacerbated by the reality that the Deposit Accounts will not be held in the U.S. but instead will be held at the London branch of a U.S. national bank, where it will be subject to English insolvency law. Further, under U.S. law, in the case of the insolvency of JPMorgan Chase Bank, N.A., the claims of creditors in respect of accounts (such as the Trust’s Deposit Accounts) that are maintained with an overseas branch of JPMorgan Chase Bank, N.A. will be subordinate to claims of creditors in respect of accounts maintained with JPMorgan Chase Bank, N.A. in the U.S., greatly increasing the risk that the Trust and the Trust’s beneficiaries would suffer a loss.

    Shareholders do not have the protections associated with ownership of shares in an investment company registered under the Investment Company Act.

    The Investment Company Act is designed to protect investors by preventing: insiders from managing investment companies to their benefit and to the detriment of public investors; the issuance of securities having inequitable or discriminatory provisions; the management of investment companies by irresponsible persons; the use of unsound or misleading methods of computing earnings and asset value; changes in the character of investment companies without the consent of investors; and investment companies from engaging in excessive leveraging. To accomplish these ends, the Investment Company Act requires the safekeeping and proper valuation of fund assets, restricts greatly transactions with affiliates, limits leveraging, and imposes governance requirements as a check on fund management. The Investment Company Act applies to a range of investment company structures, but, in practice, primarily regulates a company holding a portfolio of investment securities such as publicly traded stocks, bonds and money market instruments: selected by an affiliated investment adviser pursuant to the company’s stated investment objectives, policies, restrictions, strategies and techniques where the investment adviser manages the portfolio and otherwise operates the company on a day-to-day basis for a management fee and other charges and expenses and, in doing so, has conflicts of interest with the company; valued, priced for sale and redemption, physically held and traded in securities markets pursuant to computational, custody and brokerage and other transactional requirements peculiar to such a portfolio of investment securities; and overseen by the company’s board of directors that is elected, constituted and governed pursuant to specified standards developed in the context of such a portfolio of investment securities.

    The Trust is not registered as an investment company under the Investment Company Act and is not required to register under that Act. Consequently, Shareholders do not have the regulatory protections afforded to investors in registered investment companies.

    Shareholders do not have the rights enjoyed by investors in certain other financial instruments.

    As interests in a grantor trust, the Shares have none of the statutory rights normally associated with the ownership of shares of a business corporation, including, for example, the right to bring “oppression” or “derivative” actions. Apart from the rights afforded to them by federal and state securities laws, Shareholders have only those rights relative to the Trust, the Trust property and the Shares that are set forth in the Depositary Trust Agreement. In this connection, the Shareholders have limited voting and distribution rights. They do not have the right to elect directors. See “Description of the Shares” for a description of the limited rights of the Shareholders.

    http://fulfillment.cfgweb.com/showpdf-sku.cfg?clientcode=rdx&sku=R-FXE-1

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