Bailout

ETFs jump the shark, FactorShares edition

By Felix Salmon

Sometimes, financial innovations seem like a good idea at the time, and it’s only later, after everything has gone pear-shaped, that it becomes clear we would have been much better off without them. Other times, financial innovations are clearly a bad idea from the get-go:

Factor Advisors, a New York-based asset management firm, announced today the launch of FactorShares, the first family of spread exchange traded funds (ETFs) that allow sophisticated investors to simultaneously hold both a bull and a bear position in one leveraged ETF…

FactorShares ETFs are capital efficient, targeting a daily leverage ratio of 4:1… FactorShares ETFs seek investment results for a single day only, not for longer periods.

Some investments, in things like hedge funds or private-equity funds, are considered so risky that you need to be qualified to buy them. Other investments — public stocks listed on the NYSE are a good example — can be bought by just about anybody. FactorShares, incredibly, are in the second category.

Needless to say, no one with an ounce of common sense should go anywhere near these things. Even if you’re convinced that bonds are going to outperform stocks, you should never touch FSA, the fund which gives you a 2x leveraged long position in Treasury bonds combined with a 2x leveraged short position in the S&P 500.

Just look at the official FactorShares FAQ if you want some of the reasons: the funds certainly should never be held overnight, and “may experience tracking error intra-day”; there’s “a compounding effect and tracking error”; the leverage fluctuates and “could be higher or lower than an approximately 4:1 leverage ratio”; there’s the inevitable Management Fee, of 0.75%; “other fees apply including brokerage commissions”; the shares “are not mutual funds or any other type of investment company within the meaning of the Investment Company Act of 1940, as amended, and are not subject to regulation thereunder”; the Managing Owner has been a member of the National Futures Association only since December 2009; the shares “may be adversely or favorably impacted by contango or backwardated markets”; you have to deal with a K-1 form for tax purposes at year-end; and I’m sure there’s lots of other stuff in the various prospectuses.

What confuses me is why the SEC, the NYSE, and other institutions who consider themselves to be protecting individual investors would ever allow these things to trade openly on the stock exchange in this manner. This isn’t a company raising equity capital so that it can invest in the real economy and grow and thrive. Instead, it’s a pointless, parasitical, negative-sum financial monstrosity which will probably make a modest sum for its sponsor and lose money, on average, for anybody who invests in it. It doesn’t even serve any legitimate hedging purpose.

ETFs looked like a good idea when they started replacing index funds. But the more that this kind of thing happens, the more of a bad name they’ll have. Let’s hope regulators wake up and shut this scheme down, and lots of similar ones too. People who buy these things aren’t “sophisticated investors”; they’re really not investors at all. If they want to gamble, there’s always Vegas.

Full post as published by Macroprudential on February 24, 2011 (boomark / email).