Short ETFs under microscope as SEC pounces Tue Apr 14, 2009 7:08pm EDT By Jonathan Spicer - Analysis NEW YORK (Reuters) - The explosion of exchange-traded funds that profit from falling stocks has caught the eye of U.S. regulators looking to curb short selling, but despite their demonization by some, it's hard to blame ETFs for declines in equities. The Securities and Exchange Commission has hinted that so-called leveraged inverse ETFs such as UltraShorts could be included in new rules aimed at curbing short selling. Erik Sirri, the SEC's director of trading and markets, said last week that "we could carve them out, or could loop them in" to restrictions on short sellers. The sharp market drop has put immense political pressure on the SEC to do something to limit the shorting of individual stocks. Some critics are also leveling fire at ETFs, which trade like stocks but instead track an underlying index or basket of assets. Leveraged inverse ETFs are considered "synthetic" because they use a formula of options and other derivatives to yield two or even three times the profit when the underlying assets fall. They have allowed some trading firms to thrive throughout the downward spiral in stocks. This has raised the ire of some, especially when the assets are hard-hit shares of banks getting emergency government funding. But it is unclear how much influence ETFs have on the underlying assets, to which they are only indirectly connected. Further, the SEC's initial recommendations target the selling of borrowed equities, whereas ETFs involve the buying of funds. "Although big trading of ETFs can move indices, they basically trade derivatives, so they're really not involved with the cash markets," said Jamie Selway, managing director of institutional broker White Cap Trading. "I can see how they would create late-day volatility," said Selway, a board member at BATS Exchange, the No. 3 U.S. equities market. "But if the problem is levered bear funds that drive markets down, addressing the short selling isn't going to matter because here the manipulation happens through buying." In less than three years, the U.S. leveraged inverse ETF market has swelled from nearly nothing to $12 billion, according to Barclays data. Despite the wrenching market contraction set off last year, the U.S. leveraged inverse market has grown 26 percent in the last 12 months. The majority of these products "reset" daily, meaning investors must cash out regularly to get the proper return. This makes leveraged bear funds ideal for the growing ranks of high-frequency traders that place hundreds of orders per day, driving demand for the leveraged products and pushing them into the spotlight. This month, outspoken CNBC commentator Jim Cramer said aggressive short sellers have used ProShares' UltraShort Financials product to "pound bank stocks down," suggesting they should be banned. Cramer's on-air guest, NYSE Euronext (NYX.N) Chief Executive Duncan Niederauer, responded that the products could be "re-evaluated, potentially repositioned, and maybe even reinvented" -- but he stopped short of agreeing that a ban was warranted. The New York Stock Exchange, which like other exchanges has come to rely on ETFs to maintain growing trading volumes, later told Reuters it would ask the SEC to exempt ETFs from any new rules to curb short selling. ANOTHER EXEMPTION? Short selling is a trading strategy in which investors sell borrowed shares in the hope of buying them back later at a lower price. ETFs were mostly exempt from the SEC's original short sale rule, called the uptick rule, which was revoked in 2007. But leveraged inverse ETFs were then very new; they have now grown to represent nearly 3 percent of all U.S. ETF exposure, according to Barclays. The SEC, now back at the short sale drawing board, is seeking public comment on five proposed rules, which include circuit breakers and a modified uptick rule. One question in its 273-page document asked specifically whether ETFs should be exempt. "We don't think it's necessarily a healthy thing to be putting those types of restrictions on market price discovery," said Andy O'Rourke, senior vice president at funds provider Direxion Shares, which in November was the first to offer triple-leveraged "bear" ETFs on financials and other sectors. "We're expanding. We generally believe that we'll be able to operate as we have in the past," O'Rourke said in an interview. "They (the SEC) could put restrictions on the way our products operate, in which case we would be concerned." Direxion, managed by Rafferty Asset Management, had about $3 billion in ETF assets under management at the end of the first quarter. O'Rourke said the SEC did not ask extraordinary questions when Direxion applied to register its latest funds. Industry leader ProShares, which introduced leveraged inverse ETFs in 2006 and now provides the double-leveraged UltraShort products, as well as smaller rival Rydex, both declined to comment. Its UltraShort Financials ETF gained 12.3 percent in just one day on Tuesday as financial stocks dropped, while its UltraShort real estate ETF rose almost 16 percent. Some industry observers say the triple-leveraged inverse ETFs may run into problems as the SEC evaluates its options, but most of those interviewed said double-leveraged inverse funds should remain untouched. Compounding the questions, the SEC hasn't defined the problem that needs solving, said John Standerfer, executive vice president of financial services at Austin, Texas-based consulting firm S3. "The leveraged ETFs, in my opinion, are not driving the stock prices of the underlying stocks that make them up," Standerfer said, noting restrictions on the underlying securities will affect the ETFs anyway.
Too funny Beau. I think you need to re-write the first sentence to read "As the best (and most modest) pair trader in the universe". Why limit yourself to this planet, maybe there are some alien pair traders out there who are good, but surely pale in comparison to you. Maybe they are down even more in the last 12 months? I can only imagine how much your system would be down if you weren't the best pair trader in the world. Scary. Then again, not as scary as those extreme drawdowns on every trade. OUCH!
I like how everyone is blaming the ultrashort ETFS for part of the markets decline, quite pathetic. IF ULTRAshort ETFS didn't even exist you would have still seen this type of market decline. I can guarantee you that if the markets were up 57% YTD, talk of eliminating Short ETFS wouldn't even have been a thought in anyone's mind. Aside from that Direxion ETFS like FAZ and FAS doing over 250,000,000 shares a day shows you the interest there is in these trading instruments, the traders like them, there is over $3 Billion worth of ASSETS alone in these Direxion ETFS. I dont think they are going away anytime soon.
From March 7th 2009. Cramer has a big issue with SKF, he has mentioned this time and time again that this ETF should be banned, again if the market was in complete rally mode the thought of banning any inverse etf wouldn't matter. Funny how the biggest credit crisis took down the global market, how the biggest banks took massive risk and lost on everything and now cramer has to come out and complain about one small little inverse etf (SKF). This is from the same guy with some pathetic predictions that the "great depression is over", that "we will not have a lost decade like Japan had" and my favorite, that the "housing bottom will be found sometime over the next 2 months" Cramer's Outrage: UltraShort Financial ProShares (SKF) Cramer devoted another segment to blasting ultrashort ETFs, particularly SKF, which he calls "The ETF of mass destruction." He reiterated his argument that this particular Ultrashort is destructive, doubling the impact of a regular short position, and does not profit the investor; even as the financial sector is down 67%, SKF is at its 52-week low. While daytraders can benefit from the index, it is not for regular investors and does more harm than good. Cramer made a renewed appeal to SEC Chairwoman Mary Schapiro to ban this ETF.
Cramer is a hypocrite, as he does not complain about the 2X and 3X leverage bull ETFs, only the inverse ETFs. FAS, a 3X financial ETF, has been leading the financials for several weeks. Hedge funds are using this ETF instead of the underlying stocks. So if something is done about the inverse ETFs then the same should be done about the leveraged long ETFs too.
The funny thing is this. If you assume that that number of people using these ETFs grows every day, that means there were more people using them in the last 2 months than the 2 months prior. And yet, the markets went up overall. Man, this really torques me! SM
Some are better than others, Bob. You've obviously not noticed the trades with no drawdown. There's always drawdown on a trade, just by the bid ask spread. Matthew doesn't really elaborate on what distinguishes an "extreme" drawdown from High. In my case there all high, but extremely profitable at the same time. I suppose a profitable trader isn't supposed to take any risk? Well, these yahoos talking about only risking 2% of the account means there's not much reward. And I wouldn't have been as comfortable holding if it weren't for the fact that market drewdown 60% at the same time, and is (the market ) still net down 40%. There's only 6 other stock systems that made more than 40% last month on c2, but the caveat is that they aren't pairs systems.