May 01, 2010

Market Insights - 1 May 2010

Here is the latest issue of Market Insights, now also available on Facebook:


As always, please email your questions to: . 

In This Week's Issue
• Weekly Snapshot
• Chart Of The Week
• Weekly Barometers 
• Why Are Ratings Agencies Still Relevant?
• Straight From The Horse’s Mouth
• Do Leveraged ETFs Still Make Sense?
• More On ETFs
• Yet More On ETFs 

Weekly Snapshot
• US real GDP grew at an annual rate of 3.2% in Q1 of 2010 (ESA)
• Euro area inflation estimated at 1.5%, unemployment rate at 10.0% (Eurostat)
• CME Group hit daily FX trading volume record with a notional value of $193.3 bn (CME)
• Brazil's Central Bank ordered a 75 basis-point rise in the rate to a towering 9.5% (WSJ)
• Fed pledges to keep rates at record lows and is upbeat on economy (AP)
• S&P downgraded Spain’s debt one step, to AA, with a negative outlook (NY Times)
• The two-year Greek yield jumped 211 basis points to 21.10% on Wednesday (Business Week)
• S&P said it was lowering its rating on Greece's debt to junk status BB+ (BBC)
• BP's net profit more than doubled in Q1 to $6.08B – before the oil spill! (WSJ)
• US consumer confidence increased to 57.9, up from 52.3 in March (Conference Board)

Chart Of The Week
April was a tumultuous month for Europe and its problem child Greece.  At one point, Bond markets priced in a 50% chance of a Greek default within five years.  On Thursday, yields on 10-year Greek government bonds reached a historic 12.5%, clearly at the high end of yields of some emerging market economies.  On Friday, Bond Prices recovered and yields fell closer to 9% after Greece agreed on €24bn of austerity measures. Stay tuned to see how this Greek tragedy unfolds.


Weekly Barometers

Stock-2010-0430   FX-2010-0430

Why Are Ratings Agencies Still Relevant?
The grilling of Goldman Sachs executives during this week’s senate hearings offered a fascinating insight into some of the workings of the world’s most sophisticated investment bank.  At times, it felt like the questioning senators received a lesson in market-making 101.  Trying to be as non-judgmental as possible, I still came to the following realization:  There is a difference between knowledge and wisdom, one that could be characterized by humility or the apparent lack thereof in the case of some financial heavy weights.

Whether those executives were guilty of any wrong-doing and responsible for some of the causes of the financial crisis or not remains questionable. The market gave an initial thumbs up in favor of Goldman Sachs, whose stock was up over 2% the day after the hearing. On Friday however, Goldman’s shares dropped nearly 10% after a report of a possible criminal investigation of the firm surfaced.  

But the hearings also revealed a bit of an insight into the complex nature of the interactions between investment banks and ratings agencies.  At this point, one can only guess how massive the numerous conflicts of interests were and still are, that allowed some of the most obscure financial products to be sold with an official stamp of approval and an “A” rating.  At the basis of this conflict of interest is the simple fact that the ratings agencies are (still) being paid by those institutions who are to be rated, or whose products are to be rated. 

Despite all the negative press, the ongoing investigations and a serious backlash from investors, the markets still seem to follow the recommendations of these agencies.  It is therefore not surprising to see how Greek debt suffered a free fall recently. After a series of rather “timely” downgrades by the ratings agencies, most recently by Standard & Poor’s, the yields on 2-year Greek government bonds topped 21% this week, way above that of the most notorious and riskiest of sovereign debt issues. As the NY Times reports:

The ratings agency Standard & Poor’s lowered the debt rating of Spain on Wednesday, its third downgrade of a European country in two days.  The downgrade came one day after the S.& P. cut the ratings of Greek and Portuguese debt, moves that set off a flight by investors away from global equities and into fixed income securities, particularly those in United States dollars. The news Wednesday set off no such reaction, although an index of Spanish stocks fell about 3 percent. The S.&P. downgraded Spain’s debt one step, to AA, with a negative outlook.

At one point, the Greek 10-year yield reached 12.5% when just 6 months ago it was below 5%.  What has changed in terms of the Greek economy and finances that wasn’t clear to the ratings agencies then?  One should be rather concerned about the apparent inability of ratings agencies to better assess the credit worthiness of their targets.  The US exposure to Greece sovereign debt is relatively small.  However, as the debt crisis is spreading to other countries with the downgrade of Spain and Portugal this week, one must wonder what comparative metrics are used that make the distinction between what is still considered the “risk-free” rate in the US and other sovereign debt yields.

Straight From The Horse’s Mouth
Are ratings agencies to blame for the recent financial meltdown?  IMHO, they were an instrumental part in the complex web that allowed the housing bubble to run up to such ridiculous levels.  How about the Greek crisis?

Could they possibly be part of the problem? I firmly believe so, to the extent of worsening the crisis with a series of “timely” downgrades. But don’t take my word for it.  Let’s hear it straight from the horse’s mouth.  In an interview with CNBC, Kim Eng Tang, Director of sovereign and public international finance ratings  at Standard & Poor’s puts it like this:

“Don’t rely entirely on our ratings!”

            Click above photo to view the video


Do Leveraged ETFs Still Make Sense?
As reported by Marketwire earlier this week, Rydex|SGI will close 12 leveraged and inverse Exchange Traded Funds (ETFs). Investors gave a clear thumbs down on some of the more obscure ETFs recently which resulted in lackluster demand.  Below is a closer look at the list - good riddance...

Exchange Traded Fund Ticker Net Assets Exp. Ratio
Rydex 2x Russell 2000© ETF RRY 27.46M 0.70%
Rydex 2x S&P MidCap 400 ETF RMM 20.01M 0.71%
Rydex Inverse 2x Russell 2000© ETF RRZ 13.47M 0.71%
Rydex Inverse 2x S&P MidCap 400 ETF RMS 3.75M 0.71%
Rydex 2x S&P Select Sector Energy ETF REA 11.41M 0.70%
Rydex 2x S&P Select Sector Financial ETF RFL 22.13M 0.71%
Rydex 2x S&P Select Sector Health Care ETF RHM 3.57M 0.71%
Rydex 2x S&P Select Sector Technology ETF RTG 8.12M 0.71%
Rydex Inverse 2x Select Sector Energy ETF REC 1.25M 0.70%
Rydex Inverse 2x Select Sector Financial ETF RFN 8.02M 0.70%
Rydex Inverse 2x Select Sector Health Care ETF RHO 1.52M 0.70%
Rydex Inverse 2x Select Sector Technology ETF RTW 1.72M 0.71%

With regard to leveraged and inverse ETFs, we have been expressing our concerns in numerous articles: here; here; here and here, to list a few. Suffice it to say that the more complex ETFs are to be treated with extreme caution and are not ideally suited for average investors. 

While the demand side of leveraged ETFs may be fading, there may be another reason why ETF sponsors are putting a lid on the supply side of things.  As a result of increased public pressure and greater investor awareness, the US regulator FINRA has issued new margin requirements for leveraged ETFs which will go into effect on April 30, 2010.  FINRA Notice 09-65 details these new requirements. 

Essentially, a 2x leveraged ETF would require twice the normal margin requirement and also increased maintenance margin requirements.  In practical terms, this counterbalances the increased leverage and makes the rationale for purchasing a leveraged ETF highly questionable.  In this case, investors are much better off trading the non-leveraged ETFs which typically have much lower expense ratios.  While this is bad news for day traders (btw. they should really be trading futures if they like leverage), it’s a step in the right direction in terms of bringing excessive leverage into check.   

On a related note, we refer to an article What happens when an ETF closes.  If you are faced with such an announcement, the best course of action would be to sell your shares as soon as the announcement is made.

To find out more about ETFs that are in danger of being closed, please consider Ron Rowland’s ETF Deathwatch.

The number of exchange-traded products (ETPs) on ETF Deathwatch grew again this month.  For April, the quantity is 108 (76 ETFs and 32 ETNs), up from 104 for March.

It will be interesting to see how many of these ETFs on Deathwatch will survive the coming months after investors begin to realize the effects of the new imposed margin requirements. 

P.S.  Limiting the exposure towards market risk is a good thing, particularly for average investors.  In terms of the securities industry, the relatively high margin requirements for buying stocks, generally set at 50%, has been a well established mechanism to reign in some of the more excessive speculative investor urges.  To put these margin requirements in place or to raise them if and when needed is a relatively simple regulatory process, all things considered. 

Why on earth are there no tougher “margin requirements” i.e. down payments for purchasing property?  Buying a house with a 5% (or less) down payment is basically like trading futures.  While house prices do not fluctuate as rapidly as commodities and other futures prices, they do fluctuate as we all witnessed in the past few years.  Limiting someone’s leverage is the primary tool for risk management and should be imposed on “novice” investors such as home buyers.  Currently, the margin requirement for buying a gold futures contract is about 5.8%.  The minimum down payment for a home mortgage loan through the FHA program is still only 3.5%. Curious...

More On ETFs
The widely held believe that Mutual Funds would provide diversification and a chance to outperform the markets has been a central theme leading to the growth of the Mutual Fund industry in previous decades.  Opponents of Mutual Funds including Vanguard founder John Bogle pointed out that in fact the vast majority of mutual fund managers were not outperforming the benchmark index, the S&P 500.  That lead to the concept of indexing which provided investors with a low-cost alternative to the higher priced Mutual Funds.  The first Exchange Traded Fund, SPY and many of the Vanguard Index funds still hold to the same believe that investors are better off investing in a low cost index fund which should, over time, match general market returns as near as possible.  Those traditional index funds still do so at very low costs compared with the typical Mutual Fund charging fees of 1% and above.

With the growth of ETFs in recent years, we have also witnesses a clear trend towards more complex and sadly also much more expensive ETFs, some of which have been entering the realm of Mutual Funds in terms of fees. Below are two lists showing the least and most expensive ETFs currently available in US markets, based on info from Yahoo! Finance.

ETFs with lowest expense ratio      
Benchmark ETF Ticker Net Assets Exp. Ratio
SPDR – S&P 500 SPY 77.8B 0.09%
Fund Name Ticker Net Assets Exp. Ratio
Vanguard Total Stock Market ETF VTI 131.03B 0.07%
PIMCO 1-3 Year US Treasury Index ETF TUZ 90.64M 0.09%
iShares S&P Conservative Allocation AOK 32.01M 0.11%
iShares S&P Moderate Allocation AOM 50.19M 0.11%
iShares S&P Aggressive Allocation AOA 44.00M 0.11%
iShares S&P Growth Allocation AOR 53.46M 0.11%
iShares S&P Target Date Retirement Inc TGR 4.28M 0.11%
iShares S&P Target Date 2010 TZD 4.40M 0.11%
iShares S&P Target Date 2015 TZE 6.03M 0.11%
iShares S&P Target Date 2020 TZG 9.20M 0.11%
iShares S&P Target Date 2025 TZI 7.72M 0.11%
iShares S&P Target Date 2030 TZL 7.78M 0.11%
iShares S&P Target Date 2035 TZO 4.67M 0.11%
iShares S&P Target Date 2040 TZV 7.84M 0.11%
Vanguard Short-Term Bond ETF BSV 17.90B 0.12%
Vanguard Intermediate-Term Bond ETF BIV 10.30B 0.12%
Vanguard Long-Term Bond ETF BLV 3.02B 0.12%
Vanguard Total Bond Market ETF BND 76.68B 0.12%
SPDR Barclays Capital Aggregate Bond LAG 215.38M 0.13%
Vanguard Mega Cap 300 Gr Index ETF MGK 395.08M 0.13%


ETFs with highest expense ratio    
Fund Name Ticker Net Assets Exp. Ratio 
GS Connect S&P GSCI Enh Commodity TR ETN GSC 63.58M 1.25%
United States 12 Month Natural Gas UNL 32.43M 1.12%
GreenHaven Continuous Commodity Index GCC 239.41M 1.10%
Claymore/Zacks Dividend Rotation IRO 7.80M 0.99%
Market Vectors Gulf States Index ETF MES 10.78M 0.98%
Market Vectors Vietnam ETF VNM 131.00M 0.96%
Direxion Daily Real Estate Bull 3X Shrs DRN 62.99M 0.96%
Ultra S&P500 ProShares SSO 1.50B 0.95%
Ultra QQQ ProShares QLD 843.00M 0.95%
UltraShort MidCap400 ProShares MZZ 43.50M 0.95%
Ultra Dow30 ProShares DDM 382.90M 0.95%
Ultra MidCap400 ProShares MVV 137.12M 0.95%
Short S&P500 ProShares SH 1.49B 0.95%
Short QQQ ProShares PSQ 178.72M 0.95%
Short Dow30 ProShares DOG 245.60M 0.95%
UltraShort QQQ ProShares QID 918.50M 0.95%
UltraShort Dow30 ProShares DXD 552.69M 0.95%
Short MidCap400 ProShares MYY 33.25M 0.95%
Ultra Russell2000 ProShares UWM 215.49M 0.95%
Ultra SmallCap600 ProShares SAA 57.13M 0.95%

One could go wild now in comparing actual returns in relation to the fees charge and referencing those to the general benchmark index S&P 500, something we will publish in an upcoming paper (please email us if you like some preliminary info on this).  For the sake of brevity, let’s compare the least and most expensive ETFs and examine the returns versus the benchmark. 

To add a bit of Schadenfreude to this week’s Senate hearings and the questioning of Goldman Sachs executives, the most expensive ETF in the list is incidentally run by Goldman Sachs.  Judge for yourself how it performed compared to the least expensive ETF and the benchmark.

12-Month Returns


24-Month Returns

Yet More On ETFs
This just came in and I’d like to share these two fascinating charts, courtesy of

The first one depicts the performance (incl. all dividends) of 3 related ETFs and their comparative returns.  The 2x leveraged ETF achieves approximately double the returns whereas the 3x leveraged ETF nearly tripled the returns of the underlying.  For relatively short time horizons this works well as seen below.


As you might have guessed, all things aren’t equal and certain ETFs are doing a particularly bad job in fulfilling what some brokers call the “na├»ve investor expectations”.  The example below shows a particularly poor performance of the leveraged ETFs in comparison to the underlying.  Caveat Emptor!


Good luck and good investing!

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Kurt Brouwer said...

Just a quick point. In the section More on ETFs, you wrote, 'Opponents of mutual funds like Vanguard found John Bogle...'

Jack Bogle founded Vanguard, which is either the largest or second largest mutual fund company in the world. So, he's hardly an opponent of mutual funds.

If you wrote that he has been campaigning for lower expense mutual funds for decades, you'd be on the mark.

I enjoyed your site, in particular the post on demographics and Greece. Well done. said...

Hi Mark,
Thanks for pointing this out!
It is indeed a typo, Jack Bogle is definitely a proponent.

Thanks again!