The Toxic Avengers
- Jared Dillian
- The 10th Man
- April 30, 2020
Some malfunctioning ETFs have been in the news lately.
There was open speculation last week about whether the United States Oil Fund (USO) would fail amid all the drama in the expiring May futures contract.
Luckily for USO, it didn’t own any of those May contracts, having already rolled to June. But the Chicago Mercantile Exchange, where a lot of these contracts get traded, and the clearing firms took a hard look at the situation.
They decided it would be really bad if June oil futures went negative.
So the managers of USO rolled their June contracts into the deferred months. Then, lo and behold, June oil futures staged an impressive rally, with the contango flattening… and USO missing out on returns.
Still, USO did what it had to do—it had to truncate the very real risk that WTI would go negative again, which would likely blow up the fund.
USO has mostly disappointed investors over the years. Oil spends most of its time in contango, where the price of oil futures is higher than the spot price. Plus, this ETF has a significant cost of carry, which goes up when it rolls its oil contracts out to later-dated months.
Throngs of retail investors have been burned by the carry, watching oil trade higher and wondering why USO didn’t go along for the ride.
As for other malfunctioning ETFs, you also have the example of the junk bond ETFs, which sharply diverged from their net asset value (NAV) under market stress.
There is nothing nefarious going on here—I predicted this would happen a couple of years ago. I said that, under periods of duress, the ETFs act as a form of price discovery and the underlying bonds would catch up to NAV eventually.
Of course, now that the Fed is buying junk bonds, the credit ETFs are trading at a premium.
People also blow themselves up about a hundred different ways with the volatility ETFs. The same principles apply.There is a lot of talk about how these ETFs failed. They didn’t fail; they did exactly what they were supposed to do. It’s right there in the prospectus.
USO is actually a pretty plain-vanilla ETF. It holds front-month WTI oil futures and rolls them to the second month. That’s it. There’s nothing exotic about it.
This ETF became exotic when share creation was suspended, and it turned into a closed-end fund buying long-dated oil. Nobody knows what’s in it now.
The ETF structure is unbreakable. If you want to talk about things breaking, let’s talk about open-end credit funds that gate redemptions. People can’t get their money out—that’s no fund.
Like what you're reading?
- ETFs give you liquidity, but perhaps at the wrong price.
- Open-end funds trade at the right price, but they might not give you liquidity.
Pick your poison.
In each case, we are trying to take a basket of stuff that is not that liquid, and make it liquid. This creates a fairly common liquidity mismatch. I remember being a shareholder of Vanguard’s high-yield bond fund. It actually had check-writing privileges, if you can believe it.
Ironically, closed-end funds come under the least scrutiny. That’s because their shares are supposed to diverge from the underlying assets, sometimes by a lot. Nobody thinks twice about it.
Correspondingly, few advisers recommend closed-end funds to their clients, because those are considered exotic. In addition to getting the asset class right, you have to get the premium/discount right. Too hard. ETFs don’t do these sorts of things, or at least, they aren’t supposed to.
Finance finds a way. You never know how things will behave in a crisis, other than that people will continue to be stupid.
Retail investors continued to pile into USO even after creations were suspended, and the fund traded at a giant premium—even in the steepest contango in history—because they thought oil was going to go up. They were incinerating piles of money.
Maybe it’s easy for me to be glib about this, because I ran an ETF desk and I got to see all these products get developed. I know how they work.
The learning curve for retail investors on this stuff is very, very steep—even for an ETF that simply holds bonds. Unless you’re part of the small minority of people who have worked on a trading floor and understand liquidity, there is no way anyone can reasonably understand the liquidity mismatches.
Of course, all of this pales in comparison to leveraged ETFs, which cause more aggregate misery in the world than tobacco. Dozens of them were closed in this crisis because of excessive volatility.
When USO was created, nobody thought oil prices would go negative. When XIV was created as a bet against volatility, nobody thought the volatility index (VIX) would double in a day (well, a few people did). Finance finds a way.
If you’re wondering if your ETF could possibly malfunction, it probably can’t. But there are still wrinkles. If you ever catch me in a hotel lobby, ask me about the time I was short RTH and it didn’t participate in the Sears Holdings tender.
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