Exchange traded securities come in a variety of types offering equity traders and investors with an opportunity to participate in the other financial markets. Of course with opportunity comes risk and a key aspect to managing that risk is by first understanding it. This allows the individual to take measured risk and determine for themselves whether the security is the best vehicle to meet their objectives.

Basic Characteristics of Exchange Traded Securities

Exchange traded securities include exchange-traded notes [ETNs] and exchange-traded funds [ETFs], both of which trade on an equity exchange. Although these securities are often compared to mutual funds which actively or passively seek to match returns for a stated index, exchange traded securities trade more similarly to stock. Mutual fund structures differ quite a bit from ETNs and ETFs, which provides some advantages to the latter two.

Table 1 is taken from the 2008 Optionetics white paper, “Risks & Rewards: Achieving Your Bottom Line with ETFs” ¹, and summarize differences between mutual funds and ETFs. With the exception of the transparency line item, ETNs share these similar characteristics with ETFs. 

Table 1: Distinguishing Mutual Fund and Exchange Traded Fund Characteristics

It is assumed that the reader has a reasonable understanding of the advantages and disadvantages to exchange traded securities, including discount/premium trading, how market rules impact their trading, and commission costs associated with them.

Exchange Traded Notes

ETNs are unsecured obligations of the issuing company. They are subject to the credit-worthiness of the issuer similar to a bond, but do not provide interest payments. So in addition to assessing the risks for the security or index the ETN seeks to track, the investor needs to also assess the financial stability of the ETN issuer.

ETNs are available for currency pairs, commodities, bonds and specialty areas, such as volatility moves or buy-write strategies. Since these securities differ quite a bit from the more familiar ETF and can vary note by note, investors and traders who use them must read check the prospectus for the specific ETN to get a handle on the true risks for the instrument.

ETN returns are generally achieved from futures contracts, commodities and/or currencies held by the issuer, but may include other instruments that do not trade on an exchange. Ultimately, returns may be reliant on the health of the issuer’s financial statement and the notes held as an off balance sheet item. Return issues regarding ETNs that hold futures or commodity contracts, and/or swaps and forward agreements are included in the ETF section of this article.

Leveraged & Inverse ETFs

One characteristic specific to ETFs that provides a significant advantage to assessing their risk is transparency. ETFs are required to provide daily holdings which are often accessible via the web. By knowing which instruments a fund holds, the individual can better understand risks and costs associated with them.

For instance, a short-term government bond ETF that consistently holds ten different US Treasury Bills likely has higher transaction costs than an intermediate-term government bond ETF that needs to update the holdings less frequently. However, the costs are probably lower than a fund using the futures markets to achieve benchmark bond returns due to costs associated with rolling out near term futures contracts to later months before they expire.

Focusing on the equity ETF world, many standard ETFs (non-leveraged, non-inverse) simply hold the same underlying securities as the index it tracks. For instance, SPY, the widely traded Standard & Poor’s Depository ReceiptsTM (SPDR®) which tracks the S&P 500® Index (SPX), holds the stocks listed in the SPX using the same weighting provided by the index. Cash can also be held. As a result, SPY return tracks index changes very well and minimally impacted by market supply/demand factors, the cash holdings and fund costs.

Figure 1 provides a view of the SPY page on the www.spdrs.com website, with the link to all holdings outlined.


Figure 1: SPY Holdings Available as Part of ETF Transparency
click here for larger view

A two times (2x) leveraged fund cannot simply hold double the weight of each component since the weighting is calculated using the securities within the ETF. For equity ETFs, leveraged and inverse funds often use futures contracts and swaps to achieve the desired return. Figures 2 & 3 provide the list displayed when viewing all daily holdings for SSO and SDS, the ProShares® 2x SPX ETF and -2x SPX ETF, respectively.


Figure 2: SSO Daily Holdings (top portion of the listing)

Although the entire daily holdings list includes the stocks within SPX, the top couple of lines provide derivative holdings which are instrumental in achieving leveraged returns. SSO holds a sizable position in the near term E-mini contract for SPX. A much more substantial number of contracts are held in an S&P 500 swap with the fund assuming the payee role in the contract.


Figure 3: SDS Daily Holdings

Since an inverse fund seeks returns that are opposite the tracked index, it cannot hold long positions in the underlying stocks. Figure 3 displays a much more concise list of holdings which includes a short position in the near term E-mini contract for SPX and an S&P 500 swap with the fund assuming the payer role in the contract. 

Swaps Defined

To avoid re-inventing the wheel, the following material is an introduction to swaps and is also taken from, “Risks & Rewards: Achieving Your Bottom Line with ETFs”.

“A swap is a non-standardized agreement between two parties generally seeking to hedge a known risk. These two parties swap payments using a base investment value, referred to as the notional amount, and a widely quoted rate or index such as the London Interbank Offered Rate (LIBOR) or the S&P 500® Index. 

For example, a bank may issue a $1 million loan at a fixed rate equal to LIBOR plus 2%. When LIBOR increases, the fixed rate payments are insufficient to cover their increased borrowing costs. The bank then hedges this risk by entering into a swap agreement using LIBOR as the underlying. The bank receives payments if LIBOR increases and they make payments if LIBOR decreases. The notional amount of the swap would be $1 million, which is not exchanged by the parties.

Leveraged and short ETFs use swaps and futures contracts based on the underlying index the fund tracks. This allows a leveraged fund to obtain returns above and beyond 100% of the fund assets and short funds to increase in value when an index goes down. It should be noted that any non-standardized contract used by a fund (i.e. swaps) runs the risk of not being paid by the other party to the agreement (counter-party risk).”²

Swaps were created to hedge an existing risk. So a bank that lends substantial amounts at the current interest rate can protect against interest rate risk if rates increase by entering into a swap agreement as the receiving party.

Reducing the amounts and some mechanics to simplify the example, we start by assuming a bank lends $1 million at 1% interest (say the T-bill rate + 0.005%) to a customer who will pay back the entire amount of the loan one year from now, with interest. If T-Bill rates rise to 2% during that year, the loan is falling short on performance for these funds by 100 basis points. Rather than having interest rate risk that is unknown when the loan is made, the bank may chose to benefit from rising rates by entering into a swap agreement.

The swap agreement is created by two parties and establishes a notional amount, the party paying if rates go up, the party receiving payments if rates go up and the timing of the payments. In this case, the notional amount would be $1 million and assume payments are made once at the end of the one year term. Given a one percent increase in the T-Bill rate, the bank would receive a $10,000 payment from the paying party (its counterparty) at the end of the year.

Why would the company paying that amount want to enter into such an agreement? It may be a company with a loan that wants to reduce the costs of the loan if rates go down. There are so many different types of interest rate, currency and investment return risks, with different companies on different sides of that risk that counterparties are not working against each other as much as they are hedging an existing business with a company that shares the opposite risk.

SPX Swaps

The floating interest rate swap discussed above is clearly a very basic example, but it’s partially through example the nature of these contracts may be better understood. Let’s assume in this case the two counterparties to a swap agreement are issuers of leveraged equity ETFs. Party A is a 2x SPX ETF and Party B is a -2x SPX ETF (note this does not imply this is the arrangement for the Proshares funds identified). Party A and Party B decide to enter into a swap agreement based on the following:

• Party A holds $10,000,000 in a fund that needs to achieve a daily return equal to 2 times the change in the SPX.
• Party B holds $10,000,000 in a fund that needs to achieve a daily return equal to -2 times the change in the SPX.
• Party A will receive an amount from Party B equal to 2 x daily change in SPX x $10,000,000, if SPX rises.
• This also implies that Party B will pay Party A 2 x daily change in SPX x $10,000,000, if SPX rises.
• Party B will receive an amount from Party A equal to 2 x daily change in SPX x $10,000,000, if SPX declines.
• This also implies that Party A will pay Party B 2 x daily change in SPX x $10,000,000, if SPX declines.

So if the SPX rises 1% on Thursday, Party B will pay Party A $200,000.00. Assume the next day, SPX declines 1.5%. Then Part A will pay Party B $300,000.00 that following day.

Clearly swaps can play valuable role in these leveraged and inverse ETFs. The instruments can be customized and pay/receive rates fixed or floating. Although this basic introduction does not prepare the reader to assess counterparty risk for a variety of swap agreements. Hopefully the article does, however, provide additional insight as to how a leveraged or inverse ETF achieves a portion of its stated return.

Summary

You must understand the risks associated with instruments you trade. This means reviewing index construction methods, contract specifications, security prospectuses, daily holdings, and exchange rules, among other documents. In the case of ETNs, risks have a similar characteristic as bonds and rely on the credit-worthiness of the issuing company. For leveraged and inverse ETFs, traders must understand derivatives held by the fund and the different risks associated with those securities.

¹White, C. CMT & Kaeppel, J, (2008). Risks & Rewards: Achieving Your Bottom Line with ETFs, Optionetics (p 4).

²White, C. CMT & Kaeppel, J, (2008). Risks & Rewards: Achieving Your Bottom Line with ETFs, Optionetics (p 7).

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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