What the Market Turmoil Means for ETF Investors

“May you live in interesting times.” It turns out that this proverb (or curse, depending on how you see it)—supposedly Chinese in origin—is an American invention. It is also the title of a speech given approximately one year ago by William C. Dudley, the executive vice president of the Markets Group at the Federal Reserve Bank of New York.

At the top of Mr. Dudley’s list of “interesting” items was the fact that, at the time, AAA-rated mortgage-backed securities were selling for 85 to 90 cents on the dollar. It was something that Mr. Dudley claimed he “never expected to see—ever.” He estimated that losses in the subprime mortgage area would eventually total “$100 billion to $200 billion.”

One year later, we now know that the total bill is likely to be north of $1 trillion. And while the ongoing financial crisis has left some investors shell-shocked and others paralyzed, it has left nearly all of us confused. When the Dow Jones Industrial Average and the S&P 500 hit all-time highs in October 2007, who could have imagined that less than a year later we would be watching as venerable Wall Street firms and giant depository banks faltered and Congress contemplated the transfer of hundreds of billions of dollars’ worth of mortgage-backed securities onto the public ledger?

The quickly changing investment landscape presents a host of challenges for ETF investors. The Lehman Brothers bankruptcy and the Securities and Exchange Commission’s new trading restrictions have created an environment of uncertainty. Below, we explain some of the implications of the most recent market developments.

Lehman Brothers Indexes

Lehman Brothers, the Wall Street firm that traces its roots to cotton trading in antebellum Alabama, filed for bankruptcy on Monday, September 15. Since then, various pieces of the venerable investment house have been sold off to Barclays, the U.K. commercial and investment banking giant, and various private equity firms. Barclays, of course, is also the sponsor of the iShares family of ETFs and iPath ETNs.

To ETF investors, Lehman Brothers was perhaps best known as the index provider for many iShares and State Street ETFs. As part of the acquisition of Lehman Brothers’ North American investment banking operations, Barclays has acquired Lehman’s indexing business and plans to maintain it—an unsurprising move given that Lehman’s benchmarks are not only in widespread use but form the basis for Barclays’ own products. There is no word yet on whether Barclays has any plans for renaming or rebranding the Lehman indexes.

Lehman Brothers ETNs

The Lehman bankruptcy raises a second and much more pressing question for Lehman Brothers exchange traded note investors—namely, what happens to these securities when the issuer goes under? While Lehman wasn’t a big player in the ETN world, it did have a presence with its three Opta ETNs: the Commodity Index (RAW), the Commodity Index Agriculture (EOH) and the S&P Listed Private Equity Index (PPE).

In the most fundamental sense, ETNs represent a debt obligation of the issuer. One of the risks inherent in the Opta ETNs, then, was that Lehman might not be around to pay investors back at the maturity date. That may have seemed like a remote—indeed, nearly unthinkable—outcome even a few weeks ago. Unfortunately, the possibility of issuer default was all too real. Now, Opta ETN investors will take their place in the bankruptcy queue along with the rest of Lehman’s unsecured creditors. Eventually, they may get back a small portion of their initial investment. Although Barclays has acquired Lehman’s North American operations, there is no indication that it plans to make Opta ETN holders whole as part of that deal.

The fate of Lehman’s Opta ETNs is a good reminder for ETF and ETN investors. While commodity and equity-linked ETNs may be preferable to ETFs or traditional, actively managed mutual funds for investors looking to minimize their taxable income, the risk of issuer default is not one to be taken lightly in the current market environment.

Short-sale Ban

In an attempt to quell the stormy markets and restore confidence in the battered financial sector, the Securities and Exchange Commission announced a ban on short sales of approximately 900 financial sector stocks and a handful of others (General Motors (GM), General Electric (GE)) with large financial components, effective from September 20 to October 2, 2008. Given the SEC’s focus on stabilizing the market, there is a good possibility that the ban could be extended or expanded to encompass firms from other sectors of the economy.

Short sales, as most investors know, are sales of borrowed shares made by a seller who is hoping to profit from a decline in price. If the stock price falls, then the short seller will be able to purchase replacement shares at a lower price and pocket the difference between the initial sale price and the replacement cost as his profit. For short sellers, the more precipitously a stock’s price falls, the better.

The SEC has acknowledged that under normal market conditions, short-selling contributes to price efficiency and market liquidity, but in the current market environment, “unbridled short-selling is contributing to sudden price declines in the securities of financial institutions unrelated to true price valuation.” According to the SEC, the move was necessary because of the “essential link” between a financial firm’s stock price “and confidence in the institution.”

Whether or not you agree with the SEC’s rationale, the upshot for ETF investors was erratic trading and policy changes for some of the most popular funds on the market.

ProShares, for instance, announced that its Short Financials (SEF)—a fund that is designed to provide double the inverse of the Dow Jones Financial Index—and UltraShort Financials (SKF) funds “are not expected to accept orders from Authorized Participants to create shares until further notice.” Although SEF and SKF don’t use short positions to achieve their results, ProShares nevertheless believed it wouldn’t be able to meet its performance targets given what it assumed would be heightened demand for its products.

How do these funds achieve their results without actually taking short positions? They use a combination of futures, options, swap agreements and forward contracts to create what is sometimes called a “synthetic” short position. Under the current SEC ban, synthetic shorting of financials still appears to fall within the letter of the rule.

While existing shares of SEF and SKF can still be traded on the secondary market, ProShares is warning investors that it “cannot predict whether shares will trade above, below or at their NAV.”

Rydex, the other major fund sponsor with an inverse U.S. financial fund, the Inverse 2x S&P Select Sector Financial ETF (RFN), has similarly suspended the creation of new shares, although existing shares of RFN will continue to trade on the secondary market. Like ProShares, Rydex has cautioned investors that RFN may trade at a discount or premium to its NAV.

Apart from September 22, the first trading day under the new short-sale ban, these funds have been performing fairly predictably. Given the unpredictable regulatory environment, however, investors who are not currently holding short financial ETFs in their portfolios should approach these funds with caution. While these funds can be useful as a hedge against a financial sector meltdown, a crackdown on “synthetic shorts” by the SEC could force the wholesale suspension of short financial ETF trading.