AssetPreserver News

The investment lists at AssetPreserver.com are now free.

The idea behind these lists is to show the major stocks in an industry, some examples of low-cost funds and ETFs, and the relevant indexes. These are not investment recommendations.

One of our favorite ETF resources is now defunct. etfconnect.com has morphed itself into cefconnect.com which is closed-end funds only. etfconnect handled etfs and cefs.

Even Fidelity has denounced them. So has Schwab.

“Leveraged products are complex, carry substantial risks and are intended for short-term trading,” a warning to customers on Fidelity’s Web site said. “Most reset daily and seek to achieve their objectives on a daily basis. Due to compounding, performance over longer periods can differ significantly from the performance of the underlying index.”

Many brokers are putting restraints or downright not offering them.

FAIR Canada Executive Director Ermanno Pascutto said: “The longer you hold a leveraged or inverse Exchange Traded Fund (ETF), the greater the likelihood that you will lose money, regardless of which direction you bet.”

The Financial Industry Regulatory Authority (FINRA) in June (2009) issued a reminder to brokers and advisers, urging them to use care in selling inverse and leveraged ETFs. FINRA states that they are “unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

What is a leveraged ETF?

These ETFs use borrowed money to amplify their return, whether positive or negative. They follow a well-known index but their movement is 2 or 3 times the amount, depending on the ETF.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Since most leveraged ETFs reset each day, it is difficult to gauge long term returns; twice the daily return of an index is not twice the annual return. This means the ETFs double the daily value, not necessarily the annual value.

What’s the difference? Assume that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

How does a leveraged ETF work?

In order to deliver 2x the results, management must hold half the assets as debt. For example, if the fund is 10m in the fund, the fund must borrow 10m in order to invest 20m, or 2x, the amount in the underlying daily return of the index. Instead of borrowing, the fund uses financial derivatives, such as swaps, options, and futures.

Every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. In order to attain 2x, a corrective action must be taken. And this action is to buy or sell millions of dollars of shares every day, dramatically raising transaction costs of the fund and short-term capital gains.

Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the fund’s asset base, making it much harder to recover gains in the next market upturn. Note that this situation is called the constant leverage trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets.

How have leveraged ETFs performed?

Not very well over the long term. Here is one example (as of 30 June 2009):

UltraBull is supposed to maintain 2x performance over the S&P 500 index.
SD = 5 year standard deviation

What does this mean for me?

Leveraged ETFs are reset daily to maintain their advertised ratio.

Leveraged ETFs are intended for short-term trading: a few days at the most…day traders.

Do not expect 2x (or 3x) long-term performance out leveraged ETFs.

Understand the fund’s objectives, how it works, their expense ratio, volatility, and performance. Then decide.

What is a short sale?

First, a short sale is when stock is borrowed from a broker and paid back at a later date. The hope is the stock is at a lower price at the later date.

Fred wants to sell short 100 shares of ABC. He tells his broker and the broker borrows 100 shares from someone who owns ABC promising to pay them back. Fred immediately sells the 100 shares of ABC at current market price, say $1000 total. In 5 weeks, ABC drops to $8/share. Fred buys 100 shares at $800 and repays the broker. He pockets the difference, $200, minus commissions.

What is a naked short sale?

A naked short sale is where you simply sell the stock short without owning it. The speculator sells the stock, which he does not have, hoping to cover by the settlement date. If the stock is not delivered within 3 days, it is known as fail-to-deliver. Naked short selling can generate countless sell orders, overwhelm buyers, thus driving the price down. Failing to deliver is like issuing new stock in a company without its permission. You increase the number of shares circulating in the market, which devalues a stock.

How has this been a problem?

Remember the fall of Lehman Brothers or Bear Stearns? During that debacle, 38 millions shares of Lehman were sold as naked short sales, driving the price of Lehman shares to practically zero. The shares were not delivered to the buyers on time. Bear Stearns was done in by naked short sales, too.

What has been done?

On July 27, 2009 the SEC banned naked short selling. Now before a trader sells a security short, he or she must first borrow the security, usually from a brokerage house (traditional short selling). Now there is no fail-to-deliver since the stock is “owned”. The SEC made permanent a temporary rule requiring brokerage firms to make good on failed deliveries on T+4 — the day after a fail.

How does this help me?

The hope is banning naked short selling will reduce the volatility of the market and deep drops in company’s stock with no basis.

Pipeline master limited partnerships (MLP) are such boring investments because not much can go wrong. They are the most conservative of the natural resource MLPs and provide stable cash flow and slow growth.
In the short-term, the winter could be too warm or the summer too cool, reducing transported volumes below expectations. But pipelines don’t go out of fashion. They are not in danger of being made obsolete by new products. And, since pipelines usually don’t duplicate each others’ routes, they don’t have competition.

Increasing energy-price exposure

MLP pipelines come in two types: petroleum pipelines carrying crude oil or refined petroleum products, and natural-gas pipelines.

Petroleum-pipeline operators base their fees on the volume of product transported. They’re not affected much by the price of oil.

By contrast, natural-gas pipeline operators frequently also run gas-gathering systems, which connect wells to public pipelines as well as processing plants. Typically, gathering and processing contracts expose pipeline operators to changes in the price of natural gas and its byproducts. So natural-gas pipeline operators profit margins can vary with the price of the commodity. Some operators employ hedging strategies to reduce their susceptibility to price swings. But not all do because that limits their upside potential.

While several pipeline MLPs focus on natural gas exclusively, some petroleum-pipeline operators have recently acquired natural-gas assets and others are planning to do so. It appears that eventually, most pipeline MLPs will have at least some natural-gas pipelines, and thus, at least moderate susceptibility to price swings.

Pipelines are fee-for-service businesses. There are long-term contracts and long-lived assets. Commodity risk is minimal. Kinder Morgan, for example, gets $1.35 to move a barrel of gasoline to Phoenix from Los Angeles regardless of whether oil prices are $25 or $50.

Common Problems in Gas Pipeline Transmission

Midstream transport of natural gas is a key part of the energy commodity chain. The transport stack consists of 3 key components: gathering, transmission, and distribution. Each component faces a common set of problems when it comes to significant safety incidents. However, the causes vary by percentage for each.

Gathering Problems

The gathering system of pipelines is the key to transporting natural gas from the wellhead to plants where it can be processed for transmission (aka “sweetened”). Typically, this gas is extremely corrosive and can be dangerous, often requiring special pipelines to transport it. As a result, most safety incidents in this system of pipelines are caused by corrosion (49%). Further, approximately 20% of total gathering incidents are caused by internal corrosion.

Common Problems in Gas Pipeline Transmission

Transmission, or the shipping of gas via interstate pipelines, also suffers from a similar set of problems. Unlike pipes used for gathering, corrosion accounts for about 22% of incidents (with only about 5% due to internal corrosion). However, excavation damage accounts for approximately 23% of all safety incidents (vs. 15% in gathering) . Further, material failure such as malfunction of control equipment, faulty pipe seam welds, ruptured seals, and broken couplings are the root cause of about 18% of incidents. Finally, 11% of problems are caused by natural forces such as movement of the earth, flooding, high winds, and even lightning. The balance is due to human error and other damages.