We live in a world prone to excess. It wasn’t enough to have NFL football on Sundays and Mondays; we needed a Thursday night game too. We demanded a college football playoff, got it and now 4 teams aren’t enough. People want it to look like March Madness. If the Real Housewives of Orange County was good, then spin offs of Real Housewives all over the country is even better. No place on this planet is excess more embraced than Wall Street. Eminem said it best, “Yo, I can’t do anything in moderation. I don’t know how.” Excess has found its way to one area of Wall Street, exchange-traded products. The number of exchange-traded funds (ETFs) and exchange-traded notes (ETNs) has exploded in the last 5 years. That excess is now on the verge of financially crippling the people it should help, the individual investor.
The first ETF, designed to mirror the S&P 500, debuted to little fanfare in 1989. We now have over 2,000 exchange-traded products that invest in everything imaginable. There is even an ETF that moves 3 times, in the opposite direction, of the price of Japanese Government Bond Futures. I’m not kidding! This excess has caused 2 problems that are rearing their ugly heads.
What’s in Your Wallet?
How would you feel if you had loaned money to Lehman Brothers in the days leading up to their collapse? Well, U.S. retail investors have loaned Deutsche Bank $500MM, with no collateral and they don’t even know it.
The first problem with excess is people buy things they don’t understand and ask fewer questions than they would normally. In the investing world, this can lead to real issues.
Do you know the difference between an ETF and an ETN? If you don’t, it's ok. Most people, including advisors, don’t have no clue.
When you buy an ETF, you get an ownership stake in the fund which is structured as a separate entity. When you buy an ETN, you are lending money to the issuer of the ETN.
An ETN is an unsecured debt obligation of the issuer, which means it’s not collateralized and carries the credit risk of the issuer. This means that the market value of your PowerShares 3X Inverse Japanese Government Bond Futures ETN (JGBD), is not only affected by the price of JGB futures contracts but can also be affected by the perceived creditworthiness of the issuer. Not to mention, if the issuer goes under, you’re screwed.
Investors have placed $350MM in the DB FI Enhanced Global High Yield ETN (FIEG) and another $150MM in the DB Gold Double Long ETN (DGP). If you are one of these investors, get out now! Do not pass go and do not collect $200! When Lehman collapsed, 3 ETNs backed by Lehman, but marketed under the name “Opta,” went belly up too. Investors got nothing. They weren’t even left holding the bag because Lehman couldn’t afford to let them keep the bag.
I’m not calling for the end of DB, but the risk that FIEG and DGP investors will be looking for a bag to hold is dramatically increasing.
Deutsche Bank clears trades and engages in derivative transactions with roughly 200 of the world’s largest institutions, including some of the world’s largest hedge funds. Last week a small group of those funds protected themselves against the demise of DB. First, there was a rush to buy insurance to protect against a DB collapse. Second, hedge funds moved cash and investment positions out of DB to other institutions. Third, several hedge funds requested novation, which means they want DB replaced by different creditors on the other side of derivative trades.
Don’t worry if this is the first time you’ve heard the word “novation.” All you need to know is that it brought down Bear Sterns in a matter of days. If you’re a big boy hedge fund, saying “novation” is like saying “Beetle Juice” three times. Only instead of getting a creepy looking Michael Keaton from the late 80’s, they cause the demise of a financial institution. Once the institutional investing community loses confidence in you as a counterparty, you’re toast.
To make matters worse, Deutsche Bank has one of the world’s largest derivatives books, think AIG circa 2007. At the end of last year, DB had $46T in derivatives, which is 15% of the entire derivatives market and over 3 times the GDP of the entire Eurozone. If the run on cash deposits gets out of hand, DB will be forced to unwind those positions, and that’s when things can get ugly, for everyone.
But it’s not important for you to understand the inner workings of Deutsche Bank or have a PhD in derivatives. Just make sure you know exactly what you own, ETF or ETN?
If DB finds itself on the same page in history as Lehman and MF Global then it’s not just governments and big hedge funds that will feel the pain.
Bob from Idaho, who is up 48% this year in his Double Gold ETN backed by DB, will go from bragging at the VFW on Friday nights to losing it all.
The second problem caused by the exchange-traded excess is investor complacency. Because ETFs and ETNs trade like stocks on US exchanges, it gives investors a false sense of security. It also makes it way too easy for investors to trade markets they have no business trading.
For instance, the ETFS Physical Palladium Shares ETF (PALL), which trades palladium bullion, is one the most actively traded precious metal ETFs. Professional investors are trading the futures contracts directly, so the $500MM in PALL is all from retail investors. What in the world does Joe Six-Pack know about trading palladium?!
Another niche asset class that is gaining a lot of traction with retail investors is volatility. The most popular ETF for trading volatility is the iPath S&P 500 VIX Short-Term Futures ETN (VXX), which has approximately $1.5B in assets.
Trading volatility as an asset class is not for the faint of heart because it’s one of the more specialized areas of finance. The fact that anyone with a smart phone and an E-Trade app can buy 1000 shares of VXX, means people are playing in the volatility sandbox that shouldn’t be there.
What’s more concerning is that the number of people in that sandbox is growing exponentially when we are seeing the lowest level of volatility in decades. The average daily volume in VXX has more than tripled since last year. History was made 2 weeks ago when VXX traded more volume in one day than any company in the S&P 500 Index.
What could go wrong?!
One of the primary issues that most people are unaware of is that VXX doesn’t even come close to tracking the VIX Index. Even if you know what you’re doing, VXX can’t help you execute.
So far this year, the VIX Index is down 27%, while VXX is down 58%. Even on days when being LONG volatility is the right call, VXX doesn’t deliver. Case in point, the day after the Brexit vote was a great time to be LONG volatility. The VIX Index exploded 49% higher that day, while VXX gained just 24%.
You earn half as much upside and have to stomach twice as much downside. That sounds like the risk-reward profile of Dennis Gartman’s recommendations. No wonder people can’t get enough of it!
If you like these kinds of strategies, might I suggest a game of Sic Bo in Singapore or a game of Chuck-a-luck at Foxwoods in Connecticut? Either game gives you the same risk-reward as VXX gas, but at least you will have one hell of a story to tell.
For investing in anything, but especially any exchange-traded product, turn away from excess and keep it simple. To earn great returns, don’t invest in esoteric areas of the markets or leverage your account up so it looks like Merrill Lynch’s balance sheet before the Crisis. Great returns are generated by dutifully applying a proven framework, day in and day out, in markets you understand. The next time your friend tells you he’s making a killing in an ETF that trades the Nikkei Index denominated in Bitcoin while hedged with Hello Kitty paraphernalia, do yourself a favor and close the E-Trade app. If you don’t understand the risks, don’t invest.