IYR is an ETF loaded with commercial and residential real estate investment trusts:
Prophet.net
At 4.44%, you can get almost as much yield from a 10-year Treasury note (3.8%). Why mess around with these debt-laden monsters?
SRS of course is the 2x inverse of IYR, and URE is the 2x bull version (not a bad way to short, IMO).
I haven’t talked much about SRS and SKF in over a year, since I ditched my monster positions in them in late September ’08. I had good reasons in the shorting ban, counterparty risk (seen when some London-listed ETFs with AIG swaps were halted), and the compounding issue.
Now, inverse ETFs are nasty, nasty instruments that can wreck you if you hold them too long or don’t use stops. That said, they do have their place as convenient tools for a market timer without an options or futures account, which for better or worse, means most traders out there. But if you’re thinking about inverse ETFs and you are trading with more than 25k, ask yourself why you don’t have a futures account.
For a pure short position, there is nothing better than futures — you can put on an unlevered position or use as much gearing as any sane person could want, with no slippage, no fees and tiny commissions. Say you have a 100k trading account and you don’t want to risk it all. That’s fine, just short a single e-mini contract. With today’s index prices NQ (Nasdaq 100) is worth 37k; ES (S&P500) is worth 56.5k; TF (Russell 2k) is worth 63.5k and YM (mini Dow) is worth 53k. Some people who will put half their account into a 2x ETF think that is safer than futures. What nonsense! 50k in SDS (-200% S&P) is like selling two 2 ES contracts, except that you pay fees to ProShares and lose money if the market doesn’t fall immediately. You even lose money if the market trends sideways — how nuts is that?
Now, a 100k account could easily be blown to bits if you decide to go all-in and short a cool million worth of S&P contacts (which you can do), but then those 3x ETFs can do the same thing to you. At least with futures you know exactly where your account is going to be at any given SPX level. With ETFs, the way the market moves is as important as where it moves.
Ok, now you know what I really think. But here, for the brave or foolish or IRA-bound, is a chart of SRS and SKF:
Source: Yahoo! FInance
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I’m not saying I’d do it, but their underlying equities (as seen by IYR for REITS and XLF for financials) are some very overbought and tiring debt-addled zombies:
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If what goes down in the next round of credit panic is worse than 2008, and it very well could be, the counterparty risk in short ETFs will be very much an issue. If the markets do crash again and these ETFs soar, it could be prudent to just take the money and run on the first hard leg down.
My understanding is that these ETFs do not actually engage in plain-vanilla short selling, but use options, futures, forward contracts and swap agreements in order to perfectly track their respective indexes. The ProShares ETFs that I have been watching lately have been doing a good job of operating exactly as advertised, providing twice the inverse of the indexes on a daily basis. I expect them to continue to do so, and believe that their vital risks are still counterparty defaults and government meddling in the derivatives markets.
Page 7 of the ProShares prospectus (PDF) has a rundown of strategies employed by its short funds.
MarketWatch reports that ProShares ETFs have seen massive volume this week, especially SKF, the double short financial ETF, which benefited from earlier naked shorting restrictions.
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This is one heck of a rally. Dow futures are up 347 points on top of a 600 point rise from the intraday low yesterday afternoon. This is a gift for shorts using means other than plain short sales, since it sets us up for a spectacular failure, financials included.
Trading was suspended in London this week for some vehicles issued by ETF Securities, because the funds relied on counterparty arrangements with AIG (Reuters). The dirty little open secret of levered and short ETFs, and many others, is that they rely on swaps to get that near-perfect tracking of their underlying indexes.
“LONDON, Sept 16 (Reuters) – Some banks and brokerages ceased making markets in commodity securities backed by matching contracts from troubled insurer American International Group Inc … on Monday afternoon, ETF Securities said on Tuesday.
The affected securities are known as exchange traded commodities (ETCs).
ETF Securities said on its website it was “actively working on possible ways of providing investors with liquidity” — including arranging suitable collateral for market-makers.
As of this evening, ETF Securities was reporting that it was an apparent beneficiary of AIG’s nationalization:
AIG confirmed that last night there was an announcement by the Federal Reserve Board, that the Federal Reserve Bank of New York is providing a two-year, $85 billion secured revolving credit facility to AIG that will ensure the company can meet its liquidity needs.
AIG has continued to honour all of its obligations under our agreements with them, including processing all creations and redemptions in the usual manner and paying all redemptions due on time.
Like money market funds breaking the buck, this is one more risk that few investors have ever thought possible. Popular issuer ProShares spells it out in their prospectus (my underlining):
Swap Agreements Swap agreements are two-party contracts entered into primarily by institutional investors for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross returns to be exchanged or “swapped” between the parties are calculated with respect to a “notional amount,” e.g., the return on or increase in value of a particular dollar amount invested in a “basket” of securities representing a particular index. The Funds are subject to credit or performance risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
Now, swaps are not the only assets of these ETFs, so they may not go to zero in a counterparty default, but we don’t know exactly what fraction of a given fund is at risk. Nor do we know who the counterparties are in all of the ETFs. ProShares keeps their counterparties a secret, though they did assure us this week that Lehman and AIG were not among them.
Back to analog
Seeing as all major investment banks are on the ropes, it may be time to think about other ways to go short, such as old-fashioned short selling or buying puts. I’m a fan of LEAPS puts for a number of reasons, including the greater default protections of the options market.
Jury-rigs
It is worth mentioning that there are some work-arounds possible with levered ETFs that mitigate counterparty risk: shorting a levered long ETF or buying puts on a short ETF that you are long. Or you could allocate a small amount of capital to calls on a levered short ETF to limit your losses in case of default.
Why not more disclosure?
If ProShares or other issuers are implementing measures to eliminate counterparty risk, they should be forthright about it, otherwise we have to fear the worst. Is there more than one swap counterparty per fund? Just how much of each fund relies on uncollateralized swaps? How often is collateral rebalanced? If it is done daily, I would be OK with that. No biggie to lose out on one day’s gains, even a big day — I just don’t want to lose the whole wad.
We are entering uncharted waters here, and trust is in short supply for good reason.
The opportunity to short REITs (or IYR, a REIT-heavy ETF) is fantastic at right this moment. This is about as perfect a short set-up as you could ever wish for: securities of companies in a rapidly deteriorating sector have rebounded to near where they were a year ago when optimism was abundant and the stock market was making new highs. The ETF is actually trading where it was in the first quarter of 2006, the exact peak of real estate prices in the US.
Here is a 5-year look at IYR (I like to take the long view):
Click for sharper view. Source: Yahoo! Finance
There is a heavily traded double-short ETF, SRS, that tracks the opposite of the Dow Jone Real Estate Index with 200% magnitude on a daily basis. My preferred way to short is with LEAP puts, because despite common notions to the contrary, these options are more dummy-proof and safer in some ways than short-etfs, while allowing greater leverage so you can risk less capital on your shorts.
One more thing that makes this such a great short is that, in contrast to financials, there has not been much of a panic sell-off yet. XLF (a popular financial ETF), made a waterfall plunge from June to mid-July, which, while certainly not the final bottom, served to blow off some steam for the short-term.
I haven’t said anything about fundamentals here, but it should be obvious to anyone that commercial real estate, like residential, was heavily overbuilt because of cheap credit readily extended to Joe Blow Developers, Inc. We now have way more shopping malls, office parks and trendy urban condo complexes than we could possibly use at prices high enough allow Joe to cover his debt payments.
As the consumer gets frugal, the corporate sector contracts, and inner cities get scary again, vacancies in the respective developments will soar and rents will drop. And because this game, like housing, is played with leverage, holders of CRE are in big trouble (as are the banks that hold these loans on their books – they will soon be the not-so-proud owners of shiny new rental properties).
It should also be noted that as Treasury rates have fallen (a big red flag for the economy), there has been a little fad to buy CRE or REITS for the slightly better yield, as though they can be compared to Treasuries! Gimmie a break! Holders of this junk are in for a world of hurt, sooner rather than later.
