Ponzi Schemes

[LooseCannon101]

http://uk.businessinsider.com/harry-mar ... ?r=US&IR=T

I came across the above article whilst searching for information on Harry Markopolos, the guy who repeatedly warned the Securities and Exchange Commission in the USA of Bernie Madoff's Ponzi scheme. Mr. Markopolos believes that there are more schemes out there, perhaps involving ETFs.

Synthetic ETFs may not trade at par in a crisis as there are no real assets - only IOUs which can go to zero. Who actually values these products and can they be trusted?

[Lootman]

"In their letter to the SEC on January 13, the two whistleblowers compared the ETPs (which include ETFs and ETNs) to the subprime mortgage products that fueled the 2008 credit crisis.

They stated that many of these products may have been designed to take what were originally illiquid assets from the books of operators and bundle them into an ETP to make them appear liquid and hawk them later to gullible investors."

I think that is unmitigated bovine excrement. The majority of ETF assets are in the most liquid parts of the markets. In fact it is only in the illiquid parts (private equity, junk bonds, property, OTC securities etc) that I think ETFs are not suitable. But then again, when they fall out of bed, any kind of collective that invests in them is in trouble anyway.

[Lootman]

But........ We have seen this before with things such as CDO's and the like during the US property implosion and melt down of Freddie Mac, Fannie Mae and plenty of others. Subprime real estate debt was repackaged and given AAA status and sold on, there was no substance to the underlying assets at all. Just like a ponzi scheme.

Closer to home we had the split cap IT scandal where "safe" zero div preference shares were issued by multiple trusts and the only "assets" were shares in each other's trusts. Another ponzi-like scheme. I was bitterly disappointed by this since I had held quite a few high quality and profitable zeros prior to this happening. The split cap scene has never really recovered from it IMO. Which is a shame as zeros were a very useful tool for forward planning of future personal finance requirements.

I feel that gold ETF's that, for example, are not underpinned by real gold are yet another example. I hold a gold ETF but it is a physical gold ETF. It is possible that there is really no gold with my name on. But sometimes you do have to show some faith.

I'd argue the difference there is that, with both the "collateralised" mortgage instruments and with the split-capital debacle, there were layers of debt that meant the products were much more geared than was apparent. In the case of the splits, there was not only debt that was senior to the zeroes, but the IT's often incestuously invested in each other to boost the headline yield. Whereas with the CMOs/CDOs it was ever worse because investors relied on credit ratings that were works of pure fiction.

The vast majority of assets in ETFs are in the major markets such as the S&P 500 and the FTSE-100. And the popular, large-cap ETFs that do so are physical, meaning that the fundholder really does own underlying physical assets. I perceive the risk of holding those to be no more than the market risk of doing so via another vehicle.

Where exchange-traded products are at risk, are in a number of specific cases, which I believe can be identified:

1) The ETF uses synthetics to gain exposure. Now, I don't think that these are all risky but it does depend on the "synthetic" used. For instance, if it is based on options or futures, then they are exchange-listed and the risk is limited to the exchange itself, which is generally considered to be minimal. If instead the exposure is based on OTC derivatives like forwards and swaps, then there is credit risk with the counterparty of those contracts. Some gold ETFs are based on synthetics, as you mention, but others hold the physical.

2) It's really an ETN rather than an ETF. These are credit obligations of the issuer. If you had owned a Lehman ETN you would have been out of luck, although I believe that Lehman never issued any.

3) ETFs that employ leverage such as the "negative" ETFs and the double and treble geared ETFs. Frankly, if you buy those then you really need to know what you're doing.

4) The ETF invests in an illiquid universe. We have seen this from time to time. For instance if a stock market closes, as has happened on occasions in emerging market nations, and even in the US (in the immediate aftermath of 9/11) then the price of ETFs could go anywhere and do anything. But of course so could other collectives. There have also been much-publicised "flash crashes" but they were very short-term and things quickly got back to normal.

I think it's highly likely that some ETFs will experience problems. It's inevitable given that there are thousands of the things out there. But I believe that the damage will be limited to the more speculative and complex issues, just as the problems that splits had did not destroy the entire IT market. For a long-term investor holding a physical ETF that invests in a major market, I maintain there is no more risk than with any other collective, especially if you go with an established issuer.

[hiriskpaul]

I think it's highly likely that some ETFs will experience problems. It's inevitable given that there are thousands of the things out there. But I believe that the damage will be limited to the more speculative and complex issues, just as the problems that splits had did not destroy the entire IT market. For a long-term investor holding a physical ETF that invests in a major market, I maintain there is no more risk than with any other collective, especially if you go with an established issuer.

There is a far higher chance of fraud in many closed ended funds, such as ITs, then there are in huge physically backed ETFs managed by the likes of Vanguard, iShares or SPDR.

[LooseCannon101]

The average retail investor, probably not a member of Lemonfool, would not know the difference between a synthetic and real ETF.

As has been mentioned, a real ETF tracking the S and P 500 index, should closely follow that index through all market conditions.

Unfortunately, a synthetic ETF containing a multitude of derivatives which have been mis-priced to gain extra market share and earnings for the product provider, will not cope with a normal bear market sell-off. Those derivatives which nobody notices in a bull market, are now scrutinised and found wanting.

If I were to set up a Ponzi scheme, I would try to make it innocuous-sounding and relatively safe - perhaps a major index ETF. If I could use a well-known brand or name in the marketing, so much the better. I would set it up soon after a major market downturn, so that there would be relatively few withdrawals in the subsequent bull market. No one would question my use of dodgy derivatives so long as good commisions were on offer, and I'm sure the financial regulators would not bother me.

I believe Warren Buffett will be proved right when he said 'derivatives are weapons of mass financial destruction'. They should never be marketed, especially under the guise of a safe product, to a gullible public.

[Lootman]

If I were to set up a Ponzi scheme, I would try to make it innocuous-sounding and relatively safe - perhaps a major index ETF. If I could use a well-known brand or name in the marketing, so much the better. I would set it up soon after a major market downturn, so that there would be relatively few withdrawals in the subsequent bull market. No one would question my use of dodgy derivatives so long as good commisions were on offer, and I'm sure the financial regulators would not bother me.

I'm sure you would. But is there a shred of evidence to indicate that a "major market ETF" issuer has EVER done that?

If not then you are just wildly and mischievously speculating.

[Lootman]

If I were to set up a Ponzi scheme, I would try to make it innocuous-sounding and relatively safe - perhaps a major index ETF. If I could use a well-known brand or name in the marketing, so much the better. I would set it up soon after a major market downturn, so that there would be relatively few withdrawals in the subsequent bull market. No one would question my use of dodgy derivatives so long as good commisions were on offer, and I'm sure the financial regulators would not bother me.

I'm sure you would. But is there a shred of evidence to indicate that a "major market ETF" issuer has EVER done that?

If not then you are just wildly and mischievously speculating.

We don't know, do we? Before Madoff happened, there had never been a............ Madoff before. Before Lehman Brothers, before Enron etc.........
Before the split cap trust zeros scandal there had never been one before etc........

OK, so because it might conceivably be true, it is true?

Pigs might fly. There is no evidence for it, but I think I will start a rumour that they could, simply because nobody expects it just like nobody suspected Madoff?

Who needs evidence when all you need is speculation?

[Lootman]

all investment to a degree is a leap of faith. Do your due diligence and take your pick. But "it never happened before, so it never will" is perhaps a leap of faith too far?

But my point is that you have no evidence. It's like me claiming that you could be a child molester. You counter by pointing out that I have no evidence and then I say "ah, but nobody knew about Jimmy Saville, until they did".

Back when I worked in fund management, if we wanted to park some junk somewhere, or make some costs vanish, we would put them in the retail open-ended funds, because investors in those are typically the least sophisticated. Investors in private accounts, institutional funds, ITs and ETFs pay more attention.

If you're worried, take a look at active open-ended funds.

[hiriskpaul]

Unfortunately, a synthetic ETF containing a multitude of derivatives which have been mis-priced to gain extra market share and earnings for the product provider, will not cope with a normal bear market sell-off. Those derivatives which nobody notices in a bull market, are now scrutinised and found wanting.

If I were to set up a Ponzi scheme, I would try to make it innocuous-sounding and relatively safe - perhaps a major index ETF. If I could use a well-known brand or name in the marketing, so much the better. I would set it up soon after a major market downturn, so that there would be relatively few withdrawals in the subsequent bull market. No one would question my use of dodgy derivatives so long as good commisions were on offer, and I'm sure the financial regulators would not bother me.

This is truly fanciful. Firstly no right thinking fund manager would employ you with a scheme like that. Secondly, in order to obtain a listing an ETF has to gain regulatory approval. You have no chance of gaining regulatory approval if your proposal is to collateralize the ETF with "dodgy derivatives". Even synthetic ETFs are backed by physical securities, just not the right securities or not in the correct weights to track the index. The ETF provider then agrees to enter into a swap deal with a counterparty (usually another part of the same organisation), which takes on the risk of tracking the index for a fee. "Multitudes of derivatives" are not involved. Thirdly, even if you did manage to launch your dodgy ETF, you would struggle to sell it as the trend is to physical replication. Vanguard have never offered synthetics, iShares abandoned them over a decade ago and the remaining providers have rapidly diminishing market share. db-x trackers (Deutsche Bank) moved to physical a couple of years ago for vanilla ETFs. The only other ETF manager of note that still has synthetic ETFs tracking the S&P 500, FTSE 100, etc. is Lyxor and they are fighting a losing battle. As an example, iShares has nearly 10 times the AUM in their FTSE 100 tracker that Lyxor have and Vanguard nearly 5 times. Lyxor cannot even compete on price - iShares, Vanguard, HSBC, and even db-x trackers have lower OCFs.

Don't know where you got the idea of commissions from either, ETFs have never paid commission. No IFA would recommend a synthetic ETF over an equivalent physical ETF anyway, especially so if the physical ETF was cheaper.

I believe Warren Buffett will be proved right when he said 'derivatives are weapons of mass financial destruction'. They should never be marketed, especially under the guise of a safe product, to a gullible public.

Some derivatives are yes, but that does not stop Buffett from using them.

[hiriskpaul]

all investment to a degree is a leap of faith. Do your due diligence and take your pick. But "it never happened before, so it never will" is perhaps a leap of faith too far?

But my point is that you have no evidence. It's like me claiming that you could be a child molester. You counter by pointing out that I have no evidence and then I say "ah, but nobody knew about Jimmy Saville, until they did".

Back when I worked in fund management, if we wanted to park some junk somewhere, or make some costs vanish, we would put them in the retail open-ended funds, because investors in those are typically the least sophisticated. Investors in private accounts, institutional funds, ITs and ETFs pay more attention.

If you're worried, take a look at active open-ended funds.

Indeed! I have experienced active manager misbehavior in an OEIC and 2 VCTs. One of the advantages of ETFs (and tracker OEICs) is the elimination of rogue manager risk.

[hiriskpaul]

Get too paranoid and you end up investing in nothing. Investing involves balancing risks against potential rewards and it is impossible to make gains without taking risks. Investing in collectives inevitably introduces additional risks compared with investing in underlying securities, but has benefits. The main benefits are instant diversification and elimination of the hassles with investing directly in the underlying securities (ongoing security analysis, corporate actions, etc.)

A risk common to all collectives would be a conspiracy to defraud involving the collective manager/provider and the custodian. A risk with synthetic ETFs is the value of the underlying assets diverging from that of the index and default by the swap counterparty. More risks get introduced the moment an active manager is introduced, regardless of the type of the collective. As well as the risk of underperformance, investors need to trust that oversight is effective. Is the manager following his/her remit? Are they syphoning off funds in some way, such as taking backhanders for directing trades through particular brokers or from stock lending? Are they acting legally with respect to insider dealing, etc? Are they falsifying the value of their holdings and/or their trades?

[hiriskpaul]

It's really just like I said. Until something really bad happens, there is no evidence. The millisecond something happens, say a Lehman Bros for example, then suddenly, there is evidence everywhere you look. All the commentators with their 20:20 hindsight are then telling everyone how obvious it all was. And that "somebody" should have done something about it. And it's going to be like that forever, until we invent a time machine.

There are foreseeable risks, such as things like market risk, specific risk, credit risk. Once identified, some of these risks can be mitigated against, e.g. through diversification across markets, asset classes, brokers and collective investment schemes. There are other risks that are unforeseen, overlooked or simply dismissed as implausible, which are the risks you are talking about. These risks can be a problem as they can be difficult to assess and price. All I can say is that it is up to individual investors to do the best they can to assess and take risks, then either reap the rewards for taking risks or suffer the consequences.

[LooseCannon101]

The financial industry does not have the same moral compass as the average member of the public, which can lead to crooks like Bernie Madoff getting away with stealing billions over many years.

The regulators pretend to police the market on behalf of retail investors, but are really there to protect the industry.

When was the last occasion a whistleblower brought down a company or fund? The industry rule is 'always keep your mouth shut', and so no one finds out until the money is gone.

[Raptor]

Moderator Message:
This thread has some posts that seem to have no relation to the ops post. Please try to keep to the story. Thanks in advance. Raptor

[Lootman]

So, it all boils down to the "known unknowns" and the "unknown unknowns" then! All part of making a market.

The problem with your argument is that you can and probably should apply it to every other kind of investment as well. So why pick on ETFs? Other kinds of collectives make use of derivatives, and not all derivatives have the same risk profile - some even reduce risk.

Anything could theoretically happen but you need a reason to believe that it will, and you haven't given one. "Can happen" doesn't equate to "will happen" and if you extend your paranoia to all securities, and I think you should if you're going to be that untrusting, then as Paul says you just won't invest at all, just in case that one turns out to be the bad apple.