I don’t think Larry Fink’s recent remarks about leveraged and inverse ETFs are correct. And for the record, AdvisorShares was recently described as a firm proposing to offer an ETF “to double down on junk rated loans,” which is absolutely inaccurate.
Here are some thoughts to give a proper framework to understanding leveraged and inverse ETFs.
First, let me start by saying registered investment company funds are one of the most heavily regulated, shareholder-friendly fund structures, and that 99 percent of assets in ETFs are offered in that type of structure. Also, investors have benefited from the daily transparency of ETFs by being able to quickly and easily know exactly what their funds are holding––bonds, domestic equities, international equities, international bonds, futures, options, swaps––no matter what it is, so there is no reason for investors to be surprised about what is being held in their ETFs.
If I were to suggest a particular ETF that could have a higher risk, it might be a single-country ETF. I am favorably disposed to country funds and feel the structure is perfectly safe, but occasionally there are disruptions in some foreign markets whether it be a coup in Thailand or the closure of the Egyptian stock exchange for weeks during that country’s 2011 revolution.
There was a significant amount of concern over when the Egyptian market would reopen, as well as uncertainty over the true value of stocks held in the Egypt ETFs. Consequently, the ability to create or redeem new shares was suspended––although not the intraday trading, only the transactions at the end of the day that go directly to the fund at NAV.
Then there’s Russia. The U.S. government is freezing assets and applying sanctions, and who knows what the Russian government might do with their own stock market and what that means for a Russia ETF (though at least there would be some protection of the ETF-held ADRs, as a custodian bank takes on the security risk but not the valuation risk).
While I don’t wish or expect this would ever happen, there is presently a larger likelihood of that occurring than there is of the most liquid derivative contracts on the planet seizing up.
And not to bring up the painful past, but arguably more investors have been adversely affected by money market funds after some proved to be ticking time bombs during the financial crisis, relative to the stable $1.00 NAV.
Those funds subsequently received temporary government backing to shore up confidence in their usage. Inverse and leveraged funds didn’t need such backing, nor are they ever likely to.
The final point is that it remains unclear what kind of market environment Larry Fink envisions being problematic for leveraged ETFs. ProShares [which specializes in leveraged and inverse ETFs] launched in 2006 and has endured the Lehman blow up, a 50% market decline, the SEC restriction on shorting financial securities, and then a 100% market increase.