Caught this article on Seeking Alpha on Wednesday on the problems with using inverse ETFs.  It reminded me of a topic that I’ve debated quite a bit with Elliot Shmukler over the past two years, and have been meaning to write about here on the blog.

Since I haven’t commented much on personal finance topics lately, this seemed like an opportune time.  🙂

Quick set of definitions, if you aren’t familiar with the topic:

• ETF:  Exchange Traded Fund.  These are funds that are similar to mutual funds, except that they are traded like stocks.  For the most part, they are index funds with extremely low expenses.  In the last five years, there has been an explosion of index-based ETF funds, ranging from the plain vanilla US Stock Market to indexes only for water companies.
• Inverse ETF:  This is a fund that makes money based on the opposite direction of an index.  Example: An S&P 500 bear ETF, or inverse index, would attempt to give you a positive 20% return in the case that the S&P 500 dropped 20%.
• Double/Triple ETFs:  A double (or triple) ETF attempts to give you double (or triple) the returns of a given index.  For example, a double oil fund would attempt to give you a 20% return in the case that oil rose in price 10%.

The original discussion Elliot & I had was back in 2007, when we were comparing two hypothetical portfolios:

• Portfolio 1:  100% invested in the S&P 500
• Portfolio 2: 50% invested in cash, 50% invested in double S&P 500 ETF

At first blush, it might seem like Portfolio 2 is the winner.  After all, with Portfolio 2, it would seem that if the stock market were to drop more than 50%, Portfolio 2 would allow you to keep 50% in cash safe and sound.  If the stock market returns more than negative 50%, then the portfolio seems to offer exactly the same return as Portfolio 1.

The trick, however, is the nature of the double ETF itself.  Double ETFs are not perfect instruments – because they simulate returns using derivative contracts, they try to match their promised returns on a daily basis.  (I’m assuming here, by the way, that the simulation of returns is perfect.  In real life, these funds have an additional problem of tracking error due to the nature of the way they are implemented.)

So if on Day 1 the S&P 500 goes up 1%, the double ETF tries to return 2%.  I say “tries” because it’s rarely perfect.  If the next day the S&P 500 drops 2%, the double ETF should drop 4%.

Unfortunately, it turns out that the math for doubling daily returns does not necessarily lead to a long term result that matches the long term double of the index.

An easy example of where this breaks is to take a huge increase followed by a huge drop.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

On Day 1, the index goes up 40%.  Great news!  Your $1000 in the S&P 500 is worth $1400.  Your $1000 in the double S&P 500 ETF is now $1800, expected, for a 80% gain.  Everything is as expected on Day 1.

On Day 2, the index goes down 40%.  Bummer.  Your $1400 in the S&P 500 is now $840.  Your $2000 in the double S&P 500 ETF is now $360.  Wow.  That’s bad news.

You can see the problem.  Technically, over two days, the S&P 500 dropped 16%.   But the double S&P 500 ETF dropped 64%.  Most people assume it would have dropped 32%, which is double the two-day return.  This is the issue with percentages – the product of a series of percentage changes will not equal the product of a series of 2x those same percentage changes.  (Covered in Calculus D at most schools, for those in a nostalgic mood).

If you are skeptical, you might be thinking: “Well, Adam just picked the extreme example.  Of course a one day 40% move wipes you out. Most stock market moves are small, so the error is small.”

Unfortunately, this isn’t the case either.  A long series of small moves can lead to large errors as well.

Let’s assume a stock market where every day is either up 2% or down 2%.  In this case, we’ll go up twice for every down.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

After thirty days of +2%, +2%, -2% (10 times), here is what you are left with:

You’ll have $1214 in the S&P 500, for a 21.4% gain.  But you’ll have $1457 in the double S&P 500 ETF for a 45.7% gain.  In just thirty days, you’re off by 6.6% (in gains).  In this case, it’s a good thing, but obviously in a market like the one we’ve been having over the past six months, it can be a very bad thing.

In fact, over the long term, the errors can be fairly extreme, and whether they are to your benefit or not is based purely on the size and ordering of the volatile movements.  The only way to get ride of the errors is to have an absolutely equally distributed, linear progression of the market in one direction.  And let me be the first to say that we will never actually see that happen.

So, what’s the takeaway here?  Simple.

The errors in inverse and double/triple ETFs grow rapidly based on volatility.  In low volatility markets, they can be used for a short period with expected results.  Like options and other derivatives, however, their tracking errors make them poor choices for long term allocation or investment.

They do make interesting options for speculative bets in the short term, especially in situations where:

• You want to keep liquidity (ie, cash available)
• You want to limit your downside to 50%

But watch out for those error rates…

There wsa a good article in today’s WSJ (requires subscription) describing the unique point we hit today in the bond market.  Some durations of US Treasury bonds are now actually paying negative interest, -0.01% in some cases.

Investors around the world are stuffing their money into a mattress — otherwise known as the U.S. Treasury-bond market.

Fund managers, corporate treasurers, hedge funds, banks and central banks want to show their constituents, or bosses, their portfolios are bulletproof as year end approaches. Even with all the government’s steps to shore up the credit markets, investors aren’t taking any risks. Instead, they are willing to pay a premium, rather than collect one, to ensure they have in 2009 what they have now.

That means that someone is paying $100.00 for the priviledge of  getting back $99.99 at the end of the term.

This may sound ridiculous, unless you think of it in plain English:

“I’m willing to pay the US Government one penny to keep my $100.00 safe and sound for this duration.”

In a world of fear and deflation, this statement starts to make sense.  Hell, you might even pay more than $0.01 for that security in some cases.

Deflation is a very weird financial state.  For most people, it’s completely counter-intuitive. It’s a world where cash today is worth less than cash tomorrow.  It’s a world where commodities (like gold, silver, oil, food) get cheaper over time nominally, not more expensive.  It’s a world where you don’t buy today, because tomorrow the same product will be cheaper.

In fact, the only large segment of the population at this point who likely have an instinctive feel for deflation are people tied to high technology, primarily hardware like hard drives and semiconductors.  They’ve spent 30 years dealing with the fact that their products will be cheaper tomorrow than today.  They’ve even created high return businesses in effectively a deflationary environment.

I’m not going to go into detail about all aspects of deflation in this post.  But I did think it was worth explaining why 0% bonds might make sense.

Think about the dangers for keeping cash:

• Someone could steal it.  So you have to secure it.
• It can get physically destroyed (fire, pets, small children)
• You can invest it, but those investments may lose money (stocks, bonds, commodities, you-name-it)
• You can put it in a bank, but they may go bankrupt.  (you are protected up to $250K, but you may not get it immediately)

When people are afraid, and liquidity is rushing out of the system, 0% guaranteed by the ultimate “too big to fail” institution in the world can sound pretty good.

Now, I doubt this makes sense for individuals with dollars measured in thousands.  With those numbers, you can get 3+% on a CD, guaranteed by the FDIC.  But for institutions with millions or billions, how do you protect your cash?  Seriously.  It’s not a trivial problem when you think about it.

And no, you can’t just “go to gold”.  Even gold drops in nominal value during deflation.

Mathematically, if a country is undergoing 5% deflation per year, that means that $1000 of gold will only cost $950 in a year.   From that point of view, 0% percent interest + 5% deflation = a 5% real return on your capital, adjusted for inflation.

Yes, it seems like a monetary phenomenon from Bizzaro’s home planet, a square world where people say “goodbye” when they come and “hello” when they go.

But that’s what we’re flirting with right now, as it seems like literally $20 Trillion in nominal value may have disappeared off the planet.

The silver lining, however, is that you can make money in a deflationary market, if you re-orient your thinking.  Sell your products quickly, for cash.  Money now is worth more than money later.  Prioritize products that buyers cannot postpone.  Inventory turnover is key.

Intel has made billions turning over products that drop in value 1% a week in some cases.  It can be done.

Vanguard had a funny announcement today that I had to comment on (from Vanguard.com):

Vanguard announces share split for three exchange-traded funds

June 04, 2008 – Vanguard announced today a two-for-one split of shares of Vanguard® Total Stock Market ETF (VTI), Vanguard Emerging Markets ETF (VWO), and Vanguard Extended Market ETF (VXF). The conventional shares of the funds are not affected by this split.

The share split entitles each shareholder of record at the close of business on June 13, 2008 to receive one additional share for every share of the ETF held on that date. The additional shares are expected to be distributed to shareholders on June 17. The shares will trade at the new split-adjusted prices beginning June 18.

I need someone to explain this one to me.  After all, splitting a stock does absolutely nothing for the fundamentals of the stock.  You might argue there is some emotional, momentum-based advantage when go-go growth stocks do it, but this is an index fund.  And a Vanguard fund to boot!  I just can’t imagine the Vanguard trustees chasing momentum money, or expecting momentum money to flow to an index fund just because it’s splitting.

There is that old argument that you want to keep share prices low so “small investors” can buy a “round lot” of 100 shares… but that logic went out the door with odd lots and discount brokers about 30 years ago.

So why did they do it?  Are they trying to capture small investments under $100 with the ETF?  Brokers like E*Trade already offer free dividend reinvestment on ETFs, which allows you to buy partial shares.

Anyway, if you own any of these funds, note it in your calendar, Quicken, etc.

Weird.

Thank goodness, I was getting worried there.

For a while, Paul Krugman was making more and more sense to me.  It had me worried, because I remember distinctly feeling more and more alienated by his commentary in the past 5+ years.  But since I don’t follow him that closely, the reasons why were fading from memory.

This article snapped them back into clarity.  Oh boy, is this column off-base.

I think the point of his column here was to effectively claim that there is no social security crisis, that social security is doing just fine, and that the arguments against it are contradictory and specious.  I’m not really sure, though, because the point of the column kind of wanders.

In any case, he is right about one thing: the arguments against the stability of social security do contradict each other.  Unfortunately, what is good for the goose is good for the gander… Krugman’s arguments seem to also contradict themselves.

The fundamental argument that is correct, unfortunately, is that Social Security is going to start doing some serious damage to the Federal Budget, starting around 2018.

Krugman is correct that there is, in fact, a Social Security surplus, engineered as part of the Federal tax changes made in 1986.  This surplus, however, is not saved in any sort of marketable assets.  Instead, these trillions of fictional dollars have already been spent as part of the regular annual budget (yes, even after that we still run a deficit), leaving in their place special US Treasuries, redeemable in the future by the US Government.

What Krugman misses here is that US Treasuries are just an IOU that the US Government is writing to itself.  US Treasuries are in fact a great asset to invest in for every single entity other than the US Government. It’s as if you decided to buy a car today by lending yourself the money.  Yes, it is that silly.  Guess what happens when the right hand goes back to the left hand to get payment on that loan?

Allan Sloan sums the argument up well in the March 2008 issue of Fortune Magazine:

How can I say that, given Social Security’s $2.3 trillion (and growing) trust fund? It’s because the fund owns nothing but Treasury securities. Normally, of course, Treasury securities are the safest thing you can hold in a retirement account. But Social Security’s Treasuries won’t help cover the program’s cash shortfall, because Social Security is part of the federal government. Having one arm of the government (Social Security) own IOUs from another arm (the Treasury) doesn’t help the government as a whole cover its bills.

Here’s why the trust fund has no financial value. Say that Social Security calls the Treasury sometime in 2017 and says it needs to cash in $20 billion of securities to cover benefit checks. The only way for the Treasury to get that money is for the rest of the government to spend $20 billion less than it otherwise would (fat chance!), collect more in taxes (ditto), or borrow $20 billion more (which is what would happen). The spend-less, collect-more, and borrow-more options are exactly what they would be if there were no trust fund. Thus, the trust fund doesn’t make it any easier for the government to cover Social Security’s cash shortfalls than if there were no trust fund.

I think Krugman does a real disservice here by pretending that this fact is some sort of charade cooked up by people who want to privatize social security.  The fact is that social security, in its current structure, is part of the general budget.  It has no marketable assets beyond those US Treasuries, which the US issues at its discretion anyway.  The US has no sovereign wealth fund in marketable assets.  That means in 2016/2017 or so, we’re going to start having to pay the piper.  According to the Social Security Administration, the tab will be $96B in the red in 2020.

Sure, we can fund it with higher taxes.  Or lower spending.  Or both.  But it’s going to start hurting as soon as it goes negative.

There are a lot of potential solutions here – but none are easy, and none erase the fact that we effectively spent our $2.3 Trillion surplus before we were supposed to.  We’re going to have to pay it back, one way or another, or we’re going to have to radically rethink Social Security.

So, my apologies Mr. Krugman, but we do, in fact, have a Social Security crisis and a general budget crisis in the making.  And it’s going to be in the next decade, not in 2042.  My generation is going to end up paying a lot more for a lot less, assuming we even have a claim on assets at all when it’s all said and done.

There has been a lot of sensationalist talk in the past two weeks since the Bear Stearns acquisition by JP Morgan Chase.  I’ve seen editorials slamming the Fed for doing too little, for doing too much, for not acting soon enough, and for acting at all.

However, I’ve seen pitifully few articles that actually explain the details of what the Federal Reserve did, and why it was so revolutionary for the almost 100-year old institution.  Sure, I’ve seen commentators refer to a “$30 Billion Bailout” of Bear Stearns, especially in the context of populist rhetoric that this somehow would justify spending $30 Billion to bail out homeowners who are under-water on their mortgages.  But this isn’t really a bailout.

Well, the April 7th issue of Business Week actually has a decent article on the topic, and I recommend it to those who are seeking to understand what, exactly, the Fed did.  (Hard not to like the cartoon, also):

A few facts to glean from the article:

First, the Federal Reserve action, although structured like a loan, actually seems to behave mathematically more like equity:

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

More detail follows down the page:

Here’s how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there’s money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that’s financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn’t seem to provide for the Fed to make such equity investments. That doesn’t trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed’s founding legislation, a “discount” of a “note.”

This is an important point, because if the history of liquidity-impacted portfolios like LTCM are any indication, it’s very likely that an orderly disposal of the Bear Stearns assets could actually net gains in the long term.  More importantly, since JP Morgan takes the first $1B in losses, the Fed actually gets a bye on the first 3.3% of net loss on the portfolio, if it exists.

Now, you could argue that the Fed has put $29B of taxpayer dollars at risk, and that is true in a sense.  But the value of that risk is not the $29B number thrown around, but a complex calculation of the actual expected gain/loss here.  As I mentioned, historically, these type of crunch-induced crisis portfolios actually net out positively when given the time to unwind outside of a panic situation.

The fairest criticism I’ve seen of this action to date is the result of the raised offer from $2/share to $10/share by JP Morgan, which will not only keep Bear Stearns credit holders whole, but will also net common shareholders something of a windfall.  You could argue that shareholders should have received nothing, and that credit holders should have born the first risk traunche of the portfolio.

The problem with this argument is that it assumes that any other deal could have been workable and accepted in the limited timeframe caused by the run on Bear assets & liquidity.  These situations always seem calmer from hindsight, and beg for Monday-morning quarterbacking, but the truth is, they are negotiated in the heat of panic, and the almost audible sound of an approaching, falling knife.

Caught this in yesterday’s news:

Morgan Stanley has teamed up with Van Eck Global to launch currency exchange-traded notes offering exposure to the Chinese renminbi and the Indian rupee. The Market Vectors – Chinese Renminbi/USD ETN (NYSE Arca: CNY) and Market Vectors – Indian Rupee/USD ETN (NYSE Arca: INR) are the first exchange-traded products to offer exposure to those two currencies. They launched today on NYSE Arca.

The notes are designed to go up in value when the named currency appreciates against the U.S. dollar, and down when the dollar strengthens. The ETNs are underwritten by Morgan Stanley, and Van Eck is the marketing agent. The notes charge 0.55% in annual fees.

Full details are on Yahoo Finance.

The securities are already live and trading.  Here is a quote for the Market Vectors – Chinese Renminbi ETN (CNY), here is a quote for the Market Vectors – Indian Rupee ETN (INR).

There are a few details that are worth noting.  ETNs, or Exchange Traded Notes, are a relatively new innovation in indexes, and as a result, there are some grey areas around their long-term tax treatment.  Both notes do not actually own the currency.  Instead, you are buying a promise, from Morgan Stanley, that they will pay off a return on investment that matches the return on investment of an index that is tied to the currency.  Got it?  Yes, it’s two levels of indirection… almost like a HANDLE to the currency.  (Bonus points to old-school Mac developers who get the reference.)

Here are three caveats from the article:

First, unlike most currency products, they earn interest based on the U.S. Federal Funds interest rate … not local interest rates.�(Although they are currently similar.)

Second, these ETNs do not pay out interest income – instead, it is added to the share value of the note.�That creates a problem for investors, as the IRS has said that investors must pay taxes each year on this notional interest … even though they won’t realize the gains until they sell the note.

Finally, ETNs are debt instruments, which means investors are exposed to the credit risk of the underlying bank. Morgan Stanley seems sound, but the current market environment could give people pause.

This is an interesting option, but likely only appropriate for tax-protected accounts.  Personally, I still have a soft spot for Everbank, and it’s currency-based bank notes, CDs, and money market funds in different world currencies.

I love the web.  I can’t believe we live in a time where a guy like me can actually review the presentation behind something this momentus, in close to real time.

Credit to Paul Kedrosky’s Blog.

Slice the $270m JPMorgan just agreed to pay for Bear Stearns any way you want to and still it’s a horrible end for a storied brokerage firm. To end up paying $0.25 on the dollar for the company’s $1 in headquarters real estate, in effect, and to do it in equity, no less, is an embarrassment beyond embarrassment for people collectively incapable, at least until now, of being embarrassed.

Tragic, tragic stuff, and, we can only hope, a bottom, even if one we bounce along for some time,  to one of the worst periods in modern financial markets. But trust me, there is nothing in it for anything to be proud of, other than removing much of the Bear-specific counterparty risk that would have taken everyone in the financial market out in a major way during trading tomorrow.

Here is the NYT piece, from tomorrow’s newspaper, tonight, online.

Here is the PDF of the investor presentation.

Still digesting the news from the Fed yesterday on the new $200B Term Securities Lending Facility.  This type of arrangement has been discussed for some time as a possibility, but its still dramatic to see it unveiled like this.  This is a big deal for a couple reasons – first, it allows for 28-day loans, not just overnight, and second, it allows a much broader range of bonds as collateral, including mortgage-backed securities.  Combined with the other two $100B initiatives, the Fed has opened up over half of its $700B+ balance sheet to stabilize the credit markets.

Wow.

It’s becoming fashionable in circles to doubt the Fed.  I’ll be posting a book review of “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve” soon, and I’ve seen a lot of commentary doubting Mr. Bernanke.  All I can say at this point is that it is way too soon to be counting out the Fed.

They can’t work miracles, of course, but the power of almost unlimited resources is significant, if wielded properly.

The most fascinating aspect about central banking is it’s amazing foundation on the irrational and the immeasurable.  In the end, it’s more about confidence than anything else.  By convincing the markets that you will solve the problem, you create the confidence that increases liquidity and solves the problems.  You can’t be predictable, because, like in warfare, predictability leads to people thinking steps ahead and countering your actions.  Like a great General, you have to be unpredictable enough to instill fear and uncertainty in those who would fight against you, and through that uncertainty, ironically you win.

So you want uncertainty, but only the type that destabilizes those that would bet against you.  You want to reduce uncertainty around the likelihood of Fed success.

Got it?

If the juxtuposition sounds funny, blame it on the fact that I read the Greenspan book and a biography of George Washington all within a two week period.

Anyway, at times like this, it’s good to remember that the guy we have at the helm, at this time, is someone whose fundamental academic expertise is the mistakes made in the 1930s Great Depression, and the mistakes made in Japan in 1990s.  A quick reference from Paul Krugman:

What you probably should know is that Ben Bernanke, in his capacity as a professional economist, spent a lot of time worrying about Japan’s experience in the 1990s. (So did I.) What was so disturbing about Japan was the way monetary policy became ineffective; by the later 1990s the short-term interest rate was up against the ZLB — the “zero lower bound.” This is alternatively known as the “liquidity trap.” And once you’re there, conventional monetary policy can do no more, because interest rates can’t go below zero.

Krugman also points out that today’s TED spread indicates a mixed message – confidence seems better slightly, but not significantly.  That could be an indicator that the weight of uncertainty.  Still, in his own words, yesterday’s move was a big slap in the face for the credit markets.

I can’t wait until the weekend when I have time to dig into all of this further.