Cramer on Ultra-Short ETFs: Just Plain Wrong

By Jim Wiandt

Jim Cramer's view that ETFs are the root of all evil in today's markets is as misinformed as it is ill-advised.

For those of you who are not avid Mad Money watchers, Cramer wants to ban some ETFs, namely the ultra-short funds. Let's take a look and see if this makes any sense.

First of all, I should say that I am prejudiced against Jim Cramer ... mostly because watching his show gives me a headache. I think his ranting and frantic pumping and dumping is pretty much the epitome of what is wrong with investing media these days. Too much noise and panic and greed and not enough measured substance and sensible wisdom. That, and from the limited comments on ETFs others have sent to me in the past, it's been extremely evident that he had no idea what ETFs are or how they work. (Somebody help me on that one.) I remember just an obvious display that he had no idea what a creation or redemption was in some quote about ETFs.

So let's start there. I already think Cramer is an idiot and a blowhard. And generally he confirms that view for me when I come across him on CNBC or elsewhere. He's like a shopping mall—hard to avoid, but not pleasant, and the purveyor of a general nauseous feeling.

So what's the latest? This is one I've been asked a number of times in my own TV appearances, media interviews, etc. So clearly it's gaining currency. The idea? That ETFs are MOVING the markets, when the reality is that they're reflecting them.

His point does go beyond the simple "they've got 30%+ of equity volume so they must be driving the market" to "traders can use free leverage to push markets"—particularly to the downside.

His problem, and many of our problems, is the extreme volatility in today's markets. And there's NO denying it. Volatility is off the charts. Here are a few recent stats from the measure of market volatility, VIX (thanks to Matt Moran from the CBOE for this):

The CBOE Volatility Index (VIX) now has 19 years of price history, and in 2008, several new records were set for VIX, including the following:

• Highest VIX Level. The VIX Index reached its all-time intraday high of 89.53 on October 24, 2008. (Prior to 2008, the highest VIX level was 49.53 on October 8, 1998.)
• Highest Daily Closing VIX Level. The VIX Index closed at a record 80.86 on November 20, 2008. (The highest daily closing VIX price in previous years was 45.74 on October 8, 1998.)
• Highest Average Level. The VIX Index had its highest average daily closing price of 32.5 for the year of 2008 (through December 24), surpassing its previous high average daily closing price of 27.3 in 2002.
• Sustained High Volatility. The VIX Index closed above 50 on fifty trading days in 2008 (through December 26). (The VIX had never reached 50 before 2008.)
• Record Volatility of Volatility. The VIX Index had daily movements of 10% or more (up or down) on a record high 45 days in 2008 (through December 24) (the previous record was 42 days in 2007).

So, volatility? Yeah, we got it. And pretty much no one but traders likes it. Why? Because whipsawing markets are not exactly an emerging bull market indicator.

So, what are the reasons for the vol, and what are some things we can do? My own view is that it's the times; and uncertain, bearish markets are often highly volatile. And the markets and the economy of today, by most economists' evaluation, are as dangerous feeling as any since the Great Depression. If you're looking for some other reasons related to market structure, we're running a great piece by ex-specialist and pro-investor convert Dan McCabe in the just-released Journal of Indexes.

I would say that there's very little Dan agrees with Cramer on around these issues. But maybe Dan can step in here with some comment.

One thing I'm certain of is that Dan wouldn't agree that ETFs are driving the wild volatility. And there's just been some research released by CSFB (who put out some of my favorite and some of the most substantive research in the business and don't particularly have an ax to grind around ETFs). Their conclusions basically say that Cramer—much like Mr. Matt Hougan on commodities—is spouting nonsense, poppycock. Here's a brief summary:

(This is from a CSFB report by Ana Avramovic & Phil Mackintosh):

What is the REAL Impact of Leveraged ETFs?

There has been a lot of discussion recently about leveraged ETFs and the impact they are having on end-of-day activity, especially after an article in today's WSJ.

We examined the changes to intraday trading in our latest report, Intraday Rollercoaster Rides: Market Moves at Day's End (click the title for a link to the report).

To provide further clarification on this point, we believe that leveraged ETFs most likely do not exert significant influence on the volatility at the close, for 2 main reasons:

1) Leveraged ETFs are only around 2% of end-of-day trading

• Leveraged ETFs certainly do need to trade into the close to realign their exposure appropriately for the following day's open.
• However, we estimate that this rebalancing only accounts for less than $1.5 billion.
• Given that around $70 billion trades in the last half-hour based on our calculations, leveraged ETFs are only a very small percentage of that ($1.5 billion / $70 billion = 2%).

Source: Credit Suisse Portfolio Analysis

2) Leveraged ETFs should contribute momentum to day's moves, which is not always the case

• Leveraged ETFs (both long and short) are short gamma, meaning they must buy when the market goes up and sell when the market goes down. Thus, their activity into the close should confirm the trend from the rest of the day.
• However, we find that in October & November, the move in the last hour confirms the day's prior move only 60% of the time. If leveraged ETFs were a larger factor, that percent would be much higher.

Source: Credit Suisse Portfolio Analysis

So there you have it. There ARE structural reasons behind the leveraged ETFs causing some additional market activity around the close, but the amount of that activity is still a drop in the bucket when compared to what's going on in the market at large. So that is a pretty definitive analysis that matched my own view. There's no question that ETFs are being used more actively (and likely in more counterproductive ways) than ever before, but there's scant evidence that all of that activity is hurting other (longer) investors in the funds (quite the contrary compared to traditional mutual funds) or that ETFs are somehow tilting the market.

And finally, getting BACK to commodities: Matt—after being so abused—and disabused by me yesterday, I have just one comment for you regarding that half-hearted follow-up you posted. Where did you mail it in from? Yeah, we know people use commodities futures to hedge. And we certainly know that futures markets are often wildly off of the spot price for a variety of reasons, but people are doing myriad things with stocks (hedging, etc.) as well. Just take that into consideration when you're investing; it's all priced into the market.

Comments

[rogersails:]

I won't comment on Leveraged ETFs' impact on market dynamics, but as an investment vehicle they're pretty sketchy. The Leveraged ETFs I've looked at - long or short, compare terribly to their non leveraged counterparts. Pick 2 points in time where the non leveraged ETF is at the same price. Then look at the leveraged ETF at the same 2 points. It will have gone down in price. Monthly declines of 1% - 3% are common. Who would put their money in a mutual fund with 1% - 3% monthly management fees ? Who would borrow margin money at these rates ?
Oh, and yes, Jim Cramer is to Finance as Pro Wrestling is to sport.

2008 Dec 29 02:38 PM

[ValueInvestor:]

Well I'm looking at the CRB Encylopedia right now and the CBOE VIX index goes back to 1986, for a total of 22 years of data, not 19. Matt Moran is wrong, or simply not using the correct data. He's completely missing 1987.

During the crash of 1987 the VIX hit its all-time high of 172.79. His data isn't complete.

Also, the VIX has been over 50 on 5 other occasions (not a previous high of 49.53), so we're not really in an unprecedented period of volatility. Besides, while it may be overly volatile right now, it never lasts. Just like now the VIX is back into the 40's.

2008 Dec 29 03:47 PM

[Daryan:]

I hate to be that guy, but over at realmoney.com they had a former alternative investment analyst or something of that nature at Goldman do a 3 part analysis of these 2x and 3x ETFs and it was pretty clear that they were having an effect on the market due to the mechanics of how the trades are executed, especially in this thin market. It isn't really the leveraged etf itself that causes the problems, moreso it is the hedging that must take place by the market makers in order to make the trades at all, multiply this hedging by 2 and 3X and you do get a measurable and quantifiable effect on the overall market. I will send the author the articles and perhaps he will post his thoughts on the conclusions at a later time.

2008 Dec 29 03:57 PM

[Scalpulator:]

I agree with Cramer for a different reason: These ETFs do not track nor are pegged to a reliable basket and offer no reliable method to assess valuation. I tend to think after examining both 2x long and short ETFs they do not offer value to purchasers of these products and seem to be designed to benefit their issues exclusively.

2008 Dec 29 11:13 PM

[mark mchugh:]

I'm afraid that you are letting your personal dislike of Cramer color your perception of his message. Personally I think his rant against the leveraged ETF's (and specifically the ultra-shorts) was his finest hour.

First of all, these things can not possibly work. Like Madoff scheme, you can only make them "appear" to work. Einstein himself could not design a trading platform that could produce double long and short results consistently, day in and day out, moment by moment.

Pretending to make them work is a whole lot easier. And pushing the prices of the indexes against the bigger money is the easiest way to do it. In recent weeks the SRS's (ultrashort real estate) daily dollar volume was greater than URE (ultralong) and IYR (the index ETF) combined. If the fund was actually shorting the index, it surely would have dropped. The easiest way to profit would be to take the SRS money and buy the index (in other words - steal).

Furthermore, people don't understand how the mathematics work against them when you re-balance these funds on a daily basis. Case in point: the IYR is down 48% YTD, the URE is down 84% and the SRS is down almost 45%. A lose-lose-lose trade. Probably not what most people would have expected. ronically, the math works out, and the SRS has returned very close to twice the daily inverse of the IYR. The results a real estate bear would want are found in shorting the URE, not buying SRS.

I agree 100% with Cramer that the short ETF's were created to get around the short-selling margin requirements. The ultrashorts do that and challenge the buyers understanding of arithmetic, which works out very conveniently for the creators in most cases.

I wouldn't expect to see volume spikes in last half-hour of trading to take place in the leveraged ETF's themselves, I would expect to see trading that would impact them. All you have to do is fix it so that most people lose, so far, so good.....

There's lots of other things that you can pick on Cramer for, but I think his attacks on the leveraged ETF's are completely justified. Time will tell.

2008 Dec 29 11:17 PM

[E Nuff Sed:]

I am not sure that Cramer is not right at least partially right.

For example - a small number of speculator's took Oil to $149 . Compared to the fundamental market of oil, speculators are a small part - but their effect on prices were massive.

The price for a fungible commodity (like equities) at an instant of time is driven by the last stock traded.

Therefore when leveraged commodity like a ultra bear etf is rebalanced at the end of the day its creates a turbocharged momentum in the market, i.e. if a market has been falling all day - at the end of the day its off on a cliff, and vice versa.

I am not sure how these ETF's are contributing to the functioning of the market apart from making it more volatile. The basic fact is the stock market with these kinds of dubious innovation is looking more like a casino on steroids rather than a mechanism for capital allocation and price setting.

2008 Dec 30 12:18 AM

[Kunst:]

These ultra& ultrashort ETFs are extremely dangerous if you hold them for any length of time. Run some charts and you will see.

Examples, YTD:
China: FXI and FXP are both down 50%.
Oil industry: DUG is down 25% and DIG is down 75%.
Financials: UYG is down 85%, SKF is up 25%.
Real estate: URE is down 80%, SRS is down 45%.

DOG (ProShares 1x short Dow 30) is up 20%, DXD (same except 2x) is only up 15%. The single-leverage did better than the double!

If you hold on to these ETFs for more than a few days, you are on a losing track. Beware!

2008 Dec 30 01:06 AM

[NOWHEREMAN:]

ValueInvestor: You are right. But you will receive that all time hype from almost all Media and analyst outlets because most of them don't bother with facts over 20 years old.

This move to the downside has forced a lot of attention back into history but even though the Great Depression has been written about in great detail, you will get heated discussions on what happened when.

Its really a sad state of affairs when history is altered to push Agendas. Take the Gold/Silver Ratio for instance.

When Gold was rising to catch up to its true value after decades of price manipulation, it ran into an inflationary period and was deemed thereafter as reflective of Inflation. Silver was an Industrial metal which had deep rooted usage in photography. But the Hunts tried to corner the market at the same time as gold was rising so Silver wound up being the Poor Man's gold, and as such, wound up with a ratio. Digital cameras...bye bye ratio.

History? Why bother, if I say it and no one catches me, then it will be so.

2008 Dec 30 09:31 AM

[Greg Pinelli:]

Gold had..as anyone who knows the history, had NOTHING to do with the Hunt Brothers and the gold:silver ratio. That ratio goes back to the 19th century..and for those who haven't yet joined the 21st silvers uses go far beyond photography..try water purification..virtuall... every high tech eletrical and computer use imaginable..catch a clue.
I have to concur with mark mchugh..who is giving this two sentence clown these thumbs up?? His posts are a joke..also..how about showing some guts and using your real name? That's what I thought!!


On Dec 30 09:31 AM aitvaras wrote:

> ValueInvestor: You are right. But you will receive that all time
> hype from almost all Media and analyst outlets because most of them
> don't bother with facts over 20 years old.
>
> This move to the downside has forced a lot of attention back into
> history but even though the Great Depression has been written about
> in great detail, you will get heated discussions on what happened
> when.
>
> Its really a sad state of affairs when history is altered to push
> Agendas. Take the Gold/Silver Ratio for instance.
>
> When Gold was rising to catch up to its true value after decades
> of price manipulation, it ran into an inflationary period and was
> deemed thereafter as reflective of Inflation. Silver was an Industrial
> metal which had deep rooted usage in photography. But the Hunts tried
> to corner the market at the same time as gold was rising so Silver
> wound up being the Poor Man's gold, and as such, wound up with a
> ratio. Digital cameras...bye bye ratio.
>
> History? Why bother, if I say it and no one catches me, then it will
> be so.

2008 Dec 30 08:21 PM

[NOWHEREMAN:]

When the worlds major currencies were on the Gold Standard, the price of Gold was fixed. Silver prices were not fixed to the Gold Standard.

The ratio did not exist.

2008 Dec 31 12:30 AM