Exchange-traded funds--many stuffed with exotic derivatives--are shaking up the mutual fundindustry. Regulators want to make sure they don’t become the next financial time bomb.
By Edward Robinson Bloomberg Markets, July 2010
The skunk works at IShares’ headquarters in San Francisco is buzzing. Researchers in the development lab pore over data flashing across computer screens while colleagues refill their mugs at the coffee bar and huddle in conference rooms illuminated by translucent blue partitions.
These brainiacs, who create the exchange-traded funds that have made the BlackRock Inc. unit the kingpin of the global ETF market, took a radical departure in November from the index trackers IShares has churned out for a decade. They released a hedge fund in a box.
The IShares Diversified Alternatives Trust ETF packs the complex bets favored by hedge fund managers into one security. There’s no rock star money manager calling the shots; a computer program monitors the fund daily. Anyone with about $50 and a brokerage account can buy a share of an ETF that uses derivatives to bet on swings in stocks, government bonds, currencies and commodities around the world, Bloomberg Markets magazine reports in its July issue.
“There’s going to be a whole rash of these things coming out,” says Michael Latham, head of IShares’ U.S. and Canada operations.
A physicist named Nathan Most invented the ETF more than 20 years ago as a simple mutual fund that trades on bourses like a stock. Fund providers are now unleashing a new breed of “extreme ETFs” that use short selling, leverage and derivatives in a bid to capture a larger share of investor assets.
Double and Triple Returns
The creators range from BlackRock to startups founded by Ivy League professors. And the ETFs come in an array of styles. While “hedge fund replicators” mimic the strategies of exclusive investment pools, other ETFs offer investors easy entree to the volatile world of commodity futures trading. Some “leveraged and inverse” securities even promise to double and triple returns on moves in the Standard & Poor’s 500 Index and other benchmarks.
Assets in more than 260 such funds have soared to $40 billion globally from virtually zero in about four years, according to BlackRock.
Fund providers and registered investment advisers say that if used judiciously, extreme ETFs can help investors curb losses. In the first week of May, the Greek debt crisis triggered the most-volatile swings in U.S. stocks in more than a year. The S&P 500 dived more than 7 percent in five trading days. The ProShares Advisors LLC’s UltraShort S&P 500 ETF, which uses futures contracts and swaps to bet against the index, surged 17 percent during the same period.
‘It’s Insanity’
“If you’re not hedged these days, you’re going to get killed,” says Adam Patti, the chief executive officer of IndexIQ Advisors LLC, a firm in Rye Brook, New York, that copies hedge fund-style investing in ETFs.
John Bogle counters that extreme ETFs may be the next financial concoction to blow up in investors’ faces.
Bogle, the creator of the first index mutual fund in 1975, says these complex securities subvert the discipline of buy-and- hold investing and encourage investors to chase market-beating returns by speculating like day traders. The ProShares UltraShort S&P 500 ETF plunged 9 percent on May 10 after the stock market rallied on news that the European Union set up a bailout fund for indebted nations.
“It’s insanity,” says Bogle, 81, the founder of Vanguard Group Inc. “This is a classic case of Wall Street trying to capitalize on the worst instincts of investors.”
Some investment advisers say hedge fund replicators and their ilk may be twisting the innovative ETF into an overly complex and murky security that is dependent on derivatives.
Reining in Excesses
“I couldn’t possibly justify putting clients’ money into those because they’re brand new, not tested, and I don’t know what’s in them,” says Andrew Mathieson, the founder and managing member of Fairview Capital Investment Management LLC in Greenbrae, California. “It looks like just another way for investors to get plucked.”
Investors can examine the holdings for ETFs managed by IShares and other fund providers online.
“We believe innovation means good ideas coupled with good execution, and we focus on bringing products to market that provide greater access to a range of asset classes or investment strategies in efficient ways,” says Noel Archard, IShares’ head of product development.
Regulators are moving to rein in possible excesses. On March 25, the Securities and Exchange Commission announced it was deferring approval of new ETFs that use derivatives as its staff reviews whether fund managers are stuffing too much leverage and complexity into offerings aimed at retail investors.
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