The Fright of the Chameleon: WSJ’s ‘Intelligent Investor’ and ETF Paranoia

by: Greg Newton

One of the sagest pieces of professional advice NakedShorts ever received came early in his career from an aging hack who, with his face as dark as a midday thunderstorm, glowered over the froth on his beer and muttered, “Everything you read in the newspaper is true, except the stuff you know something about.” All the more so in these Intertubed days, when Everyman with a pixel machine can be his very own fact factory, present company included.

JasonZweig

And so to page B1 of The Wall Street Journal Saturday, where Jason Zweig’s Intelligent Investor column carries the headline ‘What to Do When Your Fancy ETF Goes R.I.P: After a Long Boom, A Bust Is Inevitable; What to Watch For.’ Gee, I wonder where this is going?

Sooner or later, Wall Street turns every good idea into a bad one. The exchange-traded fund was a good idea back in 1993: Create index funds that hold every security in a market worth owning, make the funds tradable like a stock, and keep costs and taxes low.

But here we are in 2008, and ETFs (plus their siblings, exchange-traded notes) are becoming a bad idea. With nearly 800 of the things, the proliferation has become a plague...

And then, after the Mark Hainesian rant about “many ETFs” being “so overspecialized that they make a pediatric endocrinologist seem like a family doctor who makes house calls,” not that Haines could summon up a word like endocrinologist, it goes downhill.

According to indexuniverse.com, 204 ETFs or ETNs have total net assets of less than $10 million apiece, and 369 have under $50 million in assets. That is troubling, since a fund smaller than $50 million probably loses money for the firm that sponsors it. In other words, nearly half of all ETFs are too small to survive.

But for the Pareto Principle, wherein roughly 20 percent of any business accounts for 80 percent of its profits. Many of those “too small to survive” ETFs are managed by the large ($10 billion-plus in ETF assets) providers which, like most businesses, subsidize poor performers for a variety of reasons, not least to avoid the egg-face interface consequences of closing down ETFs. The real issue with small ETFs is that they trade by appointment, and good luck with the bid-ask-NAV spreads.

The question is not whether, but when, most of them will fail.

Most? Let’s go with some, in a process currently being helped along by market makers declining to hold stagnant inventory. Not that failure is an unheard of phenomenon in other corners of the financial emporia.

To shut down, an ETF can liquidate, selling its portfolio and giving investors their money back at net asset value. (That can give you a tax headache, since you may get a capital gain you could otherwise have deferred.)

Unlike the capital gain you could otherwise have deferred when, to name names, Dow Chemical (DOW) takes out Rohm & Haas (ROH) in an all-cash deal at a 74 percent premium over its prior day close. Like having birthdays, paying taxes is one of those apparently negative outcomes that beats the living daylights out of the alternatives, including, in this case, carry forward tax losses.

Or the fund could merge with another, typically larger, ETF. Within three days, your brokerage account should have the cash proceeds from liquidation — or, in the case of a merger, an equivalent dollar amount of shares in another ETF.

I am certainly not aware of any ETF ever having merged with another, or even a prospectus that would allow it, without appropriate notice to shareholders and probably a vote. Just like regular stocks. A relative handful have restructured over the years — usually coincident with structural changes in their underlying benchmarks — but, again, those came with advance notice that gave shareholders who bothered opening their mail plenty of information and time for a considered “Should I stay or should I go” call.

And those votes are not a foregone conclusion. Last year, Deutsche Bank (NYSE:DB) wanted to double the leverage on its PowerShares-branded precious metals ETFs, but couldn’t either raise a quorum, or get enough holders on board. It subsequently offered new, levered and inverse, ETFs.

So far this year, 25 ETFs have shut down. All distributed their full net asset value to shareholders without any glitches (or commission charges).

So, move along, nothing to see here. One can almost sense Zweig’s disappointment.

Most insiders pooh-pooh the risk that anything could go wrong when ETFs close — an attitude a little too reminiscent, for my taste, of the bland reassurances Wall Street used to give about auction-rate securities.

OK, I wouldn’t take a Street Weasel’s word for anything either. But the circumstances are directly comparable. The eponymous ARSs traded continuously throughout the day on (in the overall scheme of things) transparent markets, overseen by the US Securities and Exchange Commission and subject to rules promulgated, if rarely enforced, by exchange regulators. Along with such checks and balances as usually narrow bid-ask spreads and the backstop, should one be bothered to check before trading, of a real-time NAV calculation showing any discepancies from fair value. Good point, thanks for bringing it up.

I did find one person who was candid. Nicholas Gerber, head of the Ameristock funds, closed five small ETFs in June (triggering some short-term capital gains). “We were able to liquidate our portfolios in 15 minutes,” says Mr. Gerber. But the Ameristock ETFs specialized in Treasury bonds. “If an ETF’s investing in illiquid securities and has to liquidate in distressed markets,” warns Mr. Gerber, “it will have the same problems as a hedge fund”— namely, a slight but real risk that NAV, or net asset value, may turn out to mean not asset value.

The “forced sale” risk is hardly real. Even in concentrated sector funds, most stock ETFs hold at least 20 positions, and the 5/25 concept, which means the five largest holdings shouldn’t account for more than 25 percent of the portfolio, avoids dangerous levels of single-stock concentration. In the real world, the unloading of a sub-$10 million, or even $50 million, ETF portfolio is unlikely to have any visible impact on anything.

Another oft-overlooked fact is that the assets of many endangered ETFs are not held by the public; they’re in the inventory of the market-makers and similar kindly souls who funded the initial launch (see: Ameristock funds, and five small ETFs closed in June). To adopt an acronym from its original disgraceful context, NHI: No Humans Involved. (And speaking of Ameristock, the ETFs in question were a re-run of a series that suffered a similar fate several years ago. Third time lucky, anybody? Bueller?)

Potential time-bombs do lurk, if you look hard enough. Leading candidates among those widely held by Mom and Pop investors would be (NYSEARCA:GLD) and (NYSEARCA:IAU), the gold ETFs with holdings that together rank among the world’s Top 10 largest owners of physical gold. As their buying has helped boost the barbarous relic, serious selling by ETF investors would certainly accelerate the tankage. If and when, and not necessarily in that order.

Less worrisome, but perhaps more likely, is what I call “chameleon risk.” From 2001 through the end of 2007, according to fund tracker Morningstar, 1,548 mutual funds were merged out of existence. At Alliance Bernstein Holding, shareholders in an Asian and in a European fund were shifted into a generic international fund. AXP Nasdaq 100 and AXP Total Stock Market were both absorbed into RiverSource S&P 500 index fund. All these investors ended up owning a fund different from the one they started with.

And, without in any way at all defending the always scrupulous practices of mutual fund managers, those investors were given advance notice of the merger and the opportunity to move their money elsewhere. (The real scandal is that the RiverSource S&P 500 index fund [ADIEX] charges 38 bps, compared with SPY’s 9 bps, but I digress.)

I suspect that chameleon mergers will spread from mutual funds to ETFs. Why should ETF sponsors give your money back when they can keep it by shoving you into one of their other funds?

I’m sure they’d love too. Regrettably, however, see above re: shareholders, votes, lack of assured outcome.

Here are a few guidelines for navigating the coming wave of consolidation.

Oh, this’ll be good.

Big is beautiful. If you invest in any ETF that has less than $50 million in assets, you are asking for trouble. Stick to big portfolios from the largest sponsors, like Barclays Global Investors, State Street and Vanguard Group.

Good, healthy, stodge. And if you want to invest in a ‘hot’ theme — solar, wind or nuclear energy, steel or ‘frontier’ markets, for example — fully cognizant of the risks associated with ‘hot,’ without taking individual stock risk? Or not being able to get at major players not listed on US exchanges? That little thing about freedom’s just another word for being allowed to blow yourself up? Or Barclays’ regular failure to meet its benchmarks, driven by its higher fees and statistical sampling process?

Not that stodge is always healthy. According to IndexUniverse, market moves took almost $75 billion out of US-listed ETF assets in the first half of this year — by definition, most of it from the largest sponsors — before net new inflows of $23 billion. 

Avoid the fringe. If you buy an ETF of Bulgarian casino stocks and it ends up whacking you with taxes or plunking you into a basket of Romanian Internet providers, you have no one to blame but yourself. Restrict yourself to ETFs in mainstream indexes of stocks and bonds.

Second verse, same as the first. Complete with the chameleon nonsense.

Don’t pay to get out. If you do own an ETF that is shutting down, consider how liquid its holdings are. Unless its securities are thinly traded, hang on until the fund is redeemed. That will provide you a rare parting gift: the opportunity to be cashed out without any brokerage commissions.

At last, common sense advice. Sometimes. As when a really really bad ETF idea — the MacroShares Oil Up/Down combo — hits its shutdown mark with the ‘down’ side of the pair trading around $3.00 against an NAV of $0.00. Then, you sell DCR and don’t wait around to be redeemed at zero. No, really, sell.

ETFs are investment products. Like stocks, mutual funds, and all manner of other financial confections, more than a few qualify as genuine carp that should never have had space on the markets’ shelves. Just like journalists and The Wall Street Journal’s ink-and-pixels, really.

Congratulations Jason. Take a hard-won Moron du Jour on vacation with you.

Noted with interest: From the world of unnecessary disclaimers, Zweig’s web site announces that he is not related to money manager Martin E. Zweig. We didn’t doubt it for a moment, Jace.

Disclosure: NakedShorts has numerous ETF positions, both long and short. Among those specifically mentioned here, he is long GLD. Not for love, but the money (so far, in case any members of the market Pantheon are passing by).

What to Do When Your Fancy ETF Goes R.I.P.
The Intelligent Investor [Ho, ho, ho — Ed]
by Jason Zweig
The Wall Street Journal Aug. 2 2008

ETF Industry Data - First Half of 2008
by Matthew Hougan
IndexUniverse.com Jul. 21 2008

Who is Jason Zweig?