Hidden Credit Risks of ETFs

Most exchange-traded products are index investments, backed by the actual portfolio of equities or bonds. Although an investor may be taking on the underlying risks of those portfolio holdings, they are not exposed to any risk from the issuer's financial state. For example, if  State Street (STT) were to go bankrupt (unlikely, even in these tumultuous times), investors in the  SPDRs ETF (SPY) would be made whole by their claims on the underlying stock investments held by the unit trust.

However, not all exchange-traded products have this safety. Exchange-traded notes, or ETNs, are actually promissory notes with no claim on an underlying portfolio, so they are only as trustworthy as the debt of their backing bank. Morningstar's director of ETF analysis, Scott Burns, recently wrote an article on ETNs and the credit risk that they face.

Besides ETNs' inherent credit risk, some ETFs also posses a certain amount of credit risk. Some ETFs cannot invest directly in their underlying assets, relying on swaps, futures, or other derivatives to match the return on their index. These derivatives open those ETFs to counterparty risk, the risk that the institution on the other side of their trade will default, which could leave a fund with no return on its assets or even a loss. The ETFs vulnerable to counterparty risk fall into two major categories: leveraged funds and commodities funds.

Leveraged ETFs
ProShares and Rydex are the two biggest issuers of leveraged funds, which seek to provide some multiple of the return on an index or sector. Examples include  UltraShort Financials ProShares (SKF), which seeks to provide twice the opposite of the daily return of the U.S. financials sector, and the Ultra S&P500 ProShares (SSO), which seeks to provide twice the daily return of the S&P 500 Index. These ETFs cannot invest directly in a basket of equities twice the size of their index or short-sell their entire portfolio due to restrictions on the investments allowed in a U.S. mutual fund structure, so they instead use swap derivatives to capture the desired daily leveraged returns. These index swaps are contracts traded through investment banks where one party offers to pay a fixed interest payment on a set date in the future in return for the other party offering to pay the return on an agreed-upon index such as the S&P 500. Leveraged ETFs keep the bulk of their assets in cash as collateral, then enter swap agreements based upon their asset values that replicate the desired multiple of an index's return.

The bank that issues the swap contract frequently guarantees the payments and oversees posting of collateral by both parties, but that is little comfort when investment banks are collapsing. Also, if a major counterparty defaults, as  American International Group (AIG) was threatening to earlier this week, the investment bank may not have enough capital to make the other parties whole and may be forced into default.

Although this seems like a lot of risk, there are mitigants. The first bit of good news is that, even if the swap contract is defaulted upon, the fund still holds all of its cash assets. The most a fund could lose is the return owed through a swap contract; it will never lose principal. The second bit of good news is that these swap contracts are very short-term, never written for more than 30-day periods. This gives leveraged ETFs some agility and allows them to quickly close out any exposure to investment banks that look to be edging toward bankruptcy.

We talked to representatives from both ProShares and Rydex and they indicated that their short-term contracts enabled them to minimize their funds' exposure to the collapse of Lehman Brothers and could cover the tiny losses any funds might have sustained. Still, a very swift collapse of a major investment bank or hedge fund in the near future cannot be ruled out (even with recent government moves), and it would almost certainly cause these funds to lose some of their returns, although fortunately the principal would remain secure.

Commodities ETFs
Commodities ETFs also frequently use derivatives rather than directly investing in the underlying assets. This is because it would not be practical to take custody of millions of barrels of crude oil, tons of coal, or bushels of corn in an effort to match benchmark returns. In order to replicate their stated index returns, commodity-based funds invest in futures, forwards, and swap contracts without actually taking physical delivery.

One of the largest and best-known commodities ETFs is  United States Oil Fund (USO). This fund--which is often used by institutions as an easily accessible hedging vehicle--is designed to track the movements of both light and sweet crude oil. Its portfolio consists primarily of listed crude oil futures contracts and other oil-related futures, forwards, and swaps, which are collateralized by cash, cash equivalents, and U.S. government obligations with remaining maturities of less than two years. There should be no concern here, as the fund's exposure is collateralized on a dollar-for-dollar basis with extremely liquid assets.

However, digging further, we notice that a portion of the fund's trades might be in over-the-counter contracts with investment banks, which are not as liquid as exchange-traded oil futures contracts, thus exposing the fund to credit risk associated with its counterparties. This exposure may have built up in the past, when forward contracts through investment banks were cheaper than exchange-traded contracts or could be based upon more obscure underlying assets. Although this type of counterparty risk may be present, we think commodities fund managers will seek to minimize their exposure to investment banks. They will likely sacrifice cost advantages for greater security by moving the portfolios fully into exchange-traded futures. Exchanges ensure each day that futures contracts are fully collateralized, and they require all counterparties to supply enough collateral that there is nearly zero risk of default. This rather pleasant option for commodities ETFs should help them avoid any troubles with counterparty defaults through this crisis, although it may reduce the profitability of the fund sponsors. 

ETF Analyst Bradley Kay contributed to this article.

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