Portions of this article first appeared in 200. All images reflect current conditions.
SPX: The Broad Market Benchmark
SPY is one of the most widely traded exchange traded funds [ETFs]. The Standard & Poor’s Depository ReceiptsTM (SPDR®) tracks the S&P 500® Index (:SPX) relatively well primarily because it holds the same approximate weight for each stock listed in the SPX, with some cash. Market supply-demand for SPY can cause deviations n the ETF versus its Intraday Indicative Value [IIV].
Figure 1 provides a view of the SPY page on the www.spdrs.com website, with the link to all holdings outlined.
fig 1 spy
Figure 1 SPY Holdings Available as Part of ETF Transparency
SPY was identified as a plain vanilla ETF in last week’s article due primarily to the match between the index holdings and the ETF holdings. Leveraged and inverse ETFs must achieve their returns with derivatives which complicates things. For that reason, they are referred to here as non-vanilla ETFs.
Leveraged & Inverse ETFs
ETF transparency provides investors with daily details on the fund’s holdings. This allows even newer traders the opportunity to see those holdings and assess for themselves whether or not they have a handle on how the returns are achieved. This is an important first step individuals must take to assess the instrument risk. If the instruments within the ETF are not understood, ETF risk cannot be assessed.
A two times (2x) leveraged fund cannot simply hold double the weight of each component since its components can all add to 100%. To achieve those leveraged returns, ETFs add leverage via futures contracts and swaps. Figure 2 lists the first portion of the daily holdings details for SSO, the ProShares® 2x SPX ETF.
fig 2 sso
Figure 2 SSO Daily Holdings (top portion of the listing)
If it is tough to decipher the text, some details include:
- The highlighted security is the S&P 500® June 2013 E-Mini futures contract
- Above the E-mini contract are S&P 500® SWAPS with various banks
- Below the E-mini contracts is a listing of S&P 500® stocks held
Additional detail is available on the ProShares ETF site: www.proshares.com.
The inverse funds may seem to have a less complex basket of securities since they don’t use short stock positions to achieve returns. Figure 3 provides the daily holdings details for SDS, the ProShares® -2x SPX ETF.
Now the SWAPs and E-mini contracts are simply augmented by cash.
fig 3 sds
Figure 3 SDS Daily Holdings
This discussion of SWAPs does not get into detailed risks and characteristics of the instrument; it is included to provide a very basic outline of how the derivatives work.
To avoid re-inventing the wheel, the following material is an introduction to swaps and is also taken from, “Risks & Rewards: Achieving Your Bottom Line with ETFs”.
“A swap is a non-standardized agreement between two parties generally seeking to hedge a known risk. These two parties swap payments using a base investment value, referred to as the notional amount, and a widely quoted rate or index such as the London Interbank Offered Rate (:LIBOR) or the S&P 500® Index.
For example, a bank may issue a $1 million loan at a fixed rate equal to LIBOR plus 2%. When LIBOR increases, the fixed rate payments are insufficient to cover their increased borrowing costs. The bank then hedges this risk by entering into a swap agreement using LIBOR as the underlying. The bank receives payments if LIBOR increases and they make payments if LIBOR decreases. The notional amount of the swap would be $1 million, which is not exchanged by the parties.
Leveraged and short ETFs use swaps and futures contracts based on the underlying index the fund tracks. This allows a leveraged fund to obtain returns above and beyond 100% of the fund assets and short funds to increase in value when an index goes down. It should be noted that any non-standardized contract used by a fund (i.e. swaps) runs the risk of not being paid by the other party to the agreement (counter-party risk).”1
Swaps were created to hedge an existing risk. So a bank that lends substantial amounts at the current interest rate can protect against interest rate risk if rates increase by entering into a swap agreement as the receiving party.
Reducing the amounts and some mechanics to simplify the example, we start by assuming a bank lends $1 million at 1% interest (say the T-bill rate + 0.005%) to a customer who will pay back the entire amount of the loan one year from now, with interest. If T-Bill rates rise to 2% during that year, the loan is falling short on performance for these funds by 100 basis points. Rather than having interest rate risk that is unknown when the loan is made, the bank may chose to benefit from rising rates by entering into a swap agreement.
The swap agreement is created by two parties and establishes a notional amount, the party paying if rates go up, the party receiving payments if rates go up and the timing of the payments. In this case, the notional amount would be $1 million and assume payments are made once at the end of the one year term. Given a one percent increase in the T-Bill rate, the bank would receive a $10,000 payment from the paying party (its counterparty) at the end of the year.
Why would the company paying that amount want to enter into such an agreement? It may want to reduce the cost of a loan if rates go down, among other reasons. Companies are faced with so many different types of interest rate, currency and investment risk that an entire over the counter financial market has evolved to address them. The counterparties may simply have opposing needs and are generally hedging existing business risk.
The floating interest rate swap discussed above is clearly a very basic example, but it’s partially through example the nature of these contracts may be better understood. Let’s assume in this case the two counterparties to a swap agreement are issuers of leveraged equity ETFs. Party A is a 2x SPX ETF and Party B is a -2x SPX ETF (note this does not imply this is the arrangement for the Proshares funds identified). Party A and Party B decide to enter into a swap agreement based on the following:
- Party A holds $10,000,000 in a fund that needs to achieve a daily return equal to 2 times the change in the SPX.
- Party B holds $10,000,000 in a fund that needs to achieve a daily return equal to -2 times the change in the SPX.
- Party A will receive an amount from Party B equal to 2 x daily change in SPX x $10,000,000, if SPX rises.
- This also implies that Party B will pay Party A 2 x daily change in SPX x $10,000,000, if SPX rises.
- Party B will receive an amount from Party A equal to 2 x daily change in SPX x $10,000,000, if SPX declines.
- This also implies that Party A will pay Party B 2 x daily change in SPX x $10,000,000, if SPX declines.
So if the SPX rises 1% on Thursday, Party B will pay Party A $200,000.00. Assume the next day, SPX declines 1.5%. Then Part A will pay Party B $300,000.00 that following day.
Clearly swaps can play valuable role in these leveraged and inverse ETFs. The instruments can be customized and pay/receive rates fixed or floating. Although this basic introduction does not prepare the reader to assess counterparty risk for a variety of swap agreements. Hopefully the article does, however, provide additional insight as to how a leveraged or inverse ETF achieves a portion of its stated return.
You must understand the risks associated with instruments you trade. This means reviewing index construction methods, contract specifications, security prospectuses, daily holdings, and exchange rules, among other documents. In the case of leveraged and inverse ETFs, traders must understand derivatives held by the fund and the different risks associated with those securities.
1 Optionetics. (2008). Risks & Rewards: Achieving Your Bottom Line with ETFs [White paper], p 7.
Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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