Munis dumped below market levels via ETFs

Muni ETFs have taken tremendous hits in the last few days. SPDR New York and California municipal bond ETFs in particular have underperformed the overall muni market.

Source: Ycharts

Surprisingly these NY and CA ETFs now trade with a 4-5% discount to NAV (ETFs' value is lower than the value of the underlying portfolio). That discount explains a portion of the underperformance (the index ETF discount is about 1%). But these are not closed-end funds and over time the ETF discount should disappear. Given this is not driven by credit concerns (for now), one could make money going long these state ETFs and shorting the overall index or treasuries to "lock in" the discount.

It's just amazing to see investors dumping munis indiscriminately, even if they end up selling below market levels (via ETFs at discount to NAV). Many of the higher rated (particularly longer dated) munis yield more than the equivalent treasuries on a pre-tax basis. The fear of fixed income product is outweighing the attractiveness of post-tax yields.

From an economic perspective, this is bad news for municipal finance. Several muni bond issuances have already been delayed, given the nasty volatility. Just when some had hoped that employment at the state level may have stabilized, the increased cost of funding will now create additional headwinds.

Source: U.S. Bureau of Labor Statistics 

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From our sponsor:

Index credit derivatives industry is ripe for disruption

Tadas Viskanta asked the following question on Twitter today:

He is referring to a new set of ETFs that are being launched by ProShares (see story). Each ETF will mimic a long or a short position in an index corporate credit default swap (CDS). The set covers high yield and investment grade indices both in the US and Europe. The benchmark indices are CDX and iTraxx.

This ETF launch is a response (at least in part) to the mess surrounding the the implementation of the Dodd-Frank regulation, as it pertains to derivatives (discussed here). While the regulation is aimed at the dealers, it ultimately hurts end-users - particularly the smaller ones. Fund managers bring up the following concerns:

1. CDS users are forced to select a clearing bank and have to pay that bank $400-$750 per CDS trade to clear (in some cases more). Unless you are a "member" of one of the clearinghouses, having a clearing bank is a requirement. And many asset managers will try to avoid being members because of capital requirements and other complications/restrictions.

2. There are significant legal costs to put in place documents that govern the relationship with a clearing bank. These documents are in addition to the standard ISDA documentation.

3. Most end users may need at least two clearing banks. That's because in the current model, the CDS clearing business is generally not profitable for banks in spite of the high fees (it tends to be balance sheet intensive for the banks, as they have to post large amounts of collateral with the clearinghouses - see discussion). Unless the banks can scale with a specific client, there is a risk of one of them walking away, potentially shutting the client out of the CDS market. Having two relationships reduces the risk but makes it administratively messy and more expensive.

4. Not all CDS transactions will be cleared, and those that are may not be entirely fungible across the different clearinghouses. That means that end users may end up posting double the margin for fully or partially offsetting positions.

5. Becoming "clearing-ready" can also be costly, as the users need to connect to the settlement platforms and learn the new processes.

If you are a fund who trades credit or just wants to use index CDS to hedge portfolios (anything from equities to loans), you have more options now. With ETFs there is no ISDA required and no need for clearing banks. All one needs is an equity trading account and let ProShares worry about the plumbing.

Furthermore, prime brokerage accounts will give credit for risk reducing transactions, lowering margin requirements. Larger funds can set up the so-called "prime+" accounts that circumvent Reg-T by moving equity portfolios outside the US. That allows for significant leverage on ETFs and other stock positions (although one runs counterparty risk by doing so). These prime+ accounts are quite common and a large number of funds with equity or distressed credit portfolios already have them. The ProShares index ETFs will fit nicely into such accounts and allow leverage that is comparable to trading the actual CDS.

With ETFs, there is no need to "roll" positions. When you put on a 5yr CDS position, in 6 months it's a 4.5yr position and there is a new 5yr CDS trading. You want to roll out of the 4.5 year postilion into the 5-year (the on-the-run position) because the current 5yr is more liquid. Those who have done this for years know it can be a real pain, and there is a clear advantage in having ProShares do it for you. One other added advantage is that one no longer needs to rely on MarkIt (which has a monopoly in this space) or the dealers to price index CDS daily in the portfolio. ETF pricing is available on Yahoo.

Whether there is going to be enough liquidity in the product remains to be seen. If they do become sufficiently liquid, many end users on the asset management side will jump on the opportunity. Moreover, there is talk that the CME will create futures contracts to mimic these ETFs, particularly if the trading volumes are sufficiently large. The futures industry is often in direct competition with the ETF industry, and index credit derivatives is one area that's ripe for disruption.

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From our sponsor:

US investors exiting equity mutual funds

2012 was another rough year for equity mutual funds business. In spite of relatively strong stock market performance, retail investors continued to pull their money out. This trend has been in place for quite some time (see discussion), but has accelerated this year. The outflows from US equity mutual funds were roughly $154bn this year.

Source: ISI Group

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From our sponsor:

US investors once again interested in emerging markets

Looks like interest in emerging markets stocks from US investors is picking up (after a pause that took place during the escalation of the Eurozone crisis this year). Shares outstanding of Vanguard MSCI Emerging Markets ETF (VWO) hit a new record recently. According to Bloomberg the largest non-bank holder, interestingly enough, is the State of New Jersey employees pension fund with about $45mm (followed by asset managers Bridgewater and State Street).

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Assets managed by commodity funds resume growth

Commodity funds assets under management (AUM) have started growing again. The peak was reached around the end of QE2 (summer of 2011). Since then the inflows weakened until investors began to anticipate a new round of monetary expansion from the Fed. The growth resumed this past summer (particularly in late August) in spite of weak global fundamentals.

Barclays: - Given the difficult regulatory backdrop, a slowing Chinese economy and the wide range of Macro-economic and financial market risks currently hanging over investors, this is a positive result for a sector that has been under pressure for most of the year-to-date. Whilst the net flow of funds into commodity investments for the year to date at just $7bn remains a long way below last year’s $25bn in the first eight months of the year, the consistent inflows over the past 3 months suggest a turning point in investor flows may have been reached.

Source: Barclays Capital

A big portion of the increase has been driven by precious metals, as funds such as GLD (SPDR Gold Trust) AUM hit new records. With the CFTC proposal to impose limits overruled in court (see discussion), growth in the AUM of commodity exchange traded products should resume.

Shares outstanding of GLD

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Has "worship of stocks" turned into "reverence for bonds"?

The trend started in early 2009. Net flows into fixed income mutual funds began to rise, while equity funds stayed flat. The trend continues through today, although equity ETFs have fared better than mutual funds (see discussion). But even within the ETF universe, flows into fixed income accelerated while equity ETFs grew quite gradually if at all.

Shares outstanding for SPY (S&P500 ETF)  vs LQD (investment grade bond ETF) (Bloomberg).

Given that the corporate bond market is smaller and less liquid than the equity market, that imbalance in growth of cumulative flows has driven yields/spreads to historical lows. Now some analysts are asking if corporate credit is overpriced relative to equities. One way to assess this is by looking at corporate bond yields vs. equity dividend yields.

The spread between the two has collapsed recently. One gets almost the same income holding corporate bonds as buying the S&P500 stocks. Is this the "new normal" according to PIMCO? Has the "worship of stocks" turned into the "reverence for bonds" (which is of course what Bill Gross wants)? Or are we simply looking at a market dislocation?

Source: CS

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Frenzied buying of investment grade corporate bonds

Investors seem to have a bottomless appetite for investment grade (IG) corporate paper. Issuers are coming to market to borrow money at ridiculously low rates. Even for the longer maturities the spreads are 1-2% above the corresponding treasury yield. Here are some examples:

• Tyco: 10-year notes at Treasuries + 190bp
• Markel: 10-year notes at Treasuries + 225bp (this firm is BBB)
• John Deere: 10-year notes at Treasuries + 122bp
• Caterpillar: 10-year notes at Treasuries +110bp

People are lending to CAT at 2.7% for 10 years! Who is buying this paper? Institutional investors of course, but also mutual funds, and ETFs. The ETF situation is particularly scary because it is driving some of these low yields and should be viewed as short-term money.

Below is a chart of shares outstanding for LQD, the iShares IBOXX investment grade corporate bond ETF. This thing is now $22.3 billion in assets (growing rapidly as new money pours in), and Larry Fink is opening the Champagne - again. LQD paid out 1.7% in dividends YTD (3.4% annualized) and investors can't get enough of it. People are betting that rates/spreads will go down even further and they will get capital appreciation on top of the crummy interest income. This looks like another crowded trade that is not going to end well.

LQD shares outstanding

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Long-term treasuries may be another crowded trade

Another potentially crowded trade is in long-term US treasuries. As discussed before, some view longer dated treasuries as a portfolio hedge, but the speculative component has grown dramatically.

Source: JPMorgan

One can also see a buildup in the number of shares outstanding of treasury ETFs. Here are the shares outstanding for SPDR's long-term treasury ETF (TLO) - back to the levels we saw during the crisis in October.

TLO shares outstanding

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Not enough leverage? Want more slippage? Try some GASX

For those who love risk, take a look at DirexionShares. It exemplifies the proliferation of leveraged ETFs - particularly the ones that give you three times the return (3 x ETFs). Take for example the one with the ticker symbol GASX - that's right, the same name as the famous medicine. It's an ETF that is 3x short natural gas equities.

GASX Fund Objective: - "The Direxion Daily Natural Gas Related Bear 3x ETF seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the ISE Revere Natural Gas Index. There is no guarantee the fund will meet its stated investment objective."

From its inception (about two years ago) GASX is down 38.5%. The negative 3x the natural gas index (which is what the ETF is supposed to be tracking) is up 17% for the same period. If you bet against natural gas companies 2 years ago, you would have been right, but this ETF would have lost you close to 40%. Ouch.

What makes this even more interesting is that its twin, GASL, the 3x long natural gas index ETF is is also down for that same period - a whopping 48%.

What gives? This is what's known as leveraged ETF slippage (illustrated here). Over time you lose either way. And the higher the volatility the more you lose. The chart below shows GASX daily annualized vol - over a period of 250 business days - approaching 100%. Using shorter periods, the volatility measures are even higher. That's why slippage is such a big problem.

GASX - Rolling 250 business days vol

Now if you want to find alternative ways of losing money, try some of the other Direxion ETFs. Indian equities, long-term treasuries, semiconductors - whatever your heart desires - all 3 times. Who said that derivatives and leverage was just for the big guys?

 It is in fact remarkable that this is a retail product. But no worries, there is proper disclosure.

Fact sheet disclosure: - Investing in the funds may be more volatile than investing in broadly diversified funds. The use of leverage by a fund increases the risk to the fund. The Funds are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investment. The Funds are not designed to track the underlying index over a longer period of time.

And clearly most retail investors will read this and say: "but of course, the volatility is extremely high - so I should expect some tremendous slippage risk."

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Dealers becoming less relevant in corporate bonds, activities linked to new issue volumes

Here is a follow-up on an earlier post discussing dealer inventories. Inventories (bonds held by primary dealers on their balance sheets) have in fact stabilized recently after a prolonged decline. Does that mean the dealers are finally taking some risk? Not exactly. The reason dealer inventories have stopped declining has to do with increased new issuance of corporate bonds. Under the Volcker rule dealers will be permitted to hold some inventory in primary bonds to facilitate new issue business. It is also worth it for dealers to set aside increased capital under Basel-III for these positions because they get issuance fees, significantly improving return on capital.

Corporate bond new issue by quarter (source: Barclays Capital)

Going forward dealer inventory and in particular trading volumes will be increasingly driven by new issue volumes. Dealers will hold and trade fewer "old issue" (secondary) bonds - it will be too costly under Basel-III and may not even be permitted under the Volcker rule. That means that the secondary bond markets, particularly in smaller corporate names will become illiquid. The next chart compares TRACE (trading) volumes to monthly new issue volumes, showing a linear relationship.

(source: Barclays Capital)

But even with stable inventories, primary dealers are becoming much less relevant to the overall market. The chart below compares dealer inventories in corporate paper with mutual funds and ETFs. As discussed before, when it comes to fixed income, ETFs increasingly run the show. The demand for paper and the volatility in cash corporate credit is now driven by ETF-related (and to some extent mutual funds) buying and selling.

Dealer inventories vs. funds NAV (source: Barclays Capital)

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The great asset class rebalancing

Here is the latest data from DB on fund flows for the major asset classes:

Equity mutual funds are continuing to lose ground to ETFs. The US domestic equity mutual funds have lost some $100bn since Jan of 2009, while equity ETFs are up around $50bn during this period.

Source: Deutsche Bank

But the equity asset class as a whole is losing AUM. Some of this capital is of course flowing into fixed income funds. Investment grade corporate bond mutual funds and ETFs have gained $131bn ($42bn into ETFs and $89bn into mutual funds) for the same period, while HY funds picked up $48bn ($20bn into ETFs and $28bn into mutual funds). Given the demographic changes in the US that favor fixed income as well as the loss of confidence in equity mutual funds, this trend is expected to continue.

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Mutual fund industry under pressure from ETFs

The mutual fund industry has been taking it on the chin lately. Investors are becoming increasingly disillusioned with the product. Reasons vary, but most point to years of poor performance coupled with downside risks that are higher than even the downside risks of hedge funds. In late 2008 the loss in many equity mutual funds was double that of an average hedge hedge fund. As an example the chart below compares the Fidelity Contrafund (one of the largest actively managed equity funds in the world) with the CS Hedge Fund Index in 2008.  Many other equity mutual funds performed in a similar fashion.

Credit Suisse Hedge Fund Index versus Fidelity Contra Fund (Bloomberg)

Another issue that generated dissatisfaction in mutual funds is the inherent conflict of interest in the industry.

NYT: The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.

And disappointed customers are voting with their wallets - and assets.  The total number of mutual funds has been on the decline.

Total number of mutual funds (Source: Investment Company Institute)

The market share lost by mutual funds is not surprisingly shifting to ETFs. ETF fees tend to be lower, yet they provide better liquidity and the ability to time the market, including intraday trading. That makes ETFs appealing not just to retail investors, but to institutions as well.

IndexUniverse: Exchange-traded funds pulled in twice as much new money as mutual funds did in 2011 in what amounts to the latest sign that the ETF juggernaut is gathering momentum, increasingly at the expense of mutual funds.

ETF assets (source: InvestnRetire)

Traditional mutual funds gathered $58.58 billion in net new money in 2011, according to estimates by Morningstar, the Chicago-based financial data firm. That compares to inflows of more than $119 billion into ETFs last year, according to data compiled by IndexUniverse.

It’s a surprising outcome in that the mutual fund industry is about seven times as big as the ETF industry in terms of assets under management.

The chart below shows that the competition for market share, at least in the equity asset class, really started around 2006 as asset flows into mutual funds and ETFs diverged.

Source: Credit Suisse

The worst loss of assets has been in the actively managed mutual funds. That is not surprising given they tend to charge higher fees and on average underperform equity indices.

IndexUniverse Without the inflows into passive funds, actively managed funds of all stripes shed about $6.7 billion in 2011.

This trend should continue as investors look to the most efficient products to express their views.  And right now paying fees for an actively managed fund that is expected to underperform just doesn't look that efficient.

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Be careful when buying ETFs at premium to NAV

The start of 2012 saw a large spike in shares outstanding of a number of fixed income ETFs, particularly the high yield oriented funds. One of the largest high yield ETFs is the iShares HY fund managed by Blackrock known by its ticker symbol as HYG. Below is a chart showing the recent spike in shares outstanding.

HYG (HY ETF) Shares Outstanding (Bloomberg)

This spike in shares outstanding corresponds to over 6% or almost $700mm increase in market value of the fund. In the high yield bond market, that's a substantial number, particularly given that this is only one of several large HY ETFs (JNK is another large one). Some have interpreted this as an acceleration of capital inflows into fixed income funds. However the reality has more to do with liquidity than fund inflows.

At the end of 2011 HYG started trading at a premium to NAV as demand for yield outweighed the Europe fears. Typically dealers would arbitrage this premium by buying bonds (a basket of bonds that represents the ETF's holdings) in the market and delivering them to the manager in return for additional shares. They would then sell the new shares at a premium, capturing some of the difference between the ETF price and it's NAV. However as liquidity dried up at the end of last year, dealers could not locate the bonds they needed for this transaction. At the start of the new year, liquidity improved and the dealers were able to buy the bonds to create new shares. With all the new shares flooding the market, the price came down while the NAV came up (demand for the basket of bonds increased). As the chart below shows, the premium to NAV declined.  In effect the inflows into this ETF happened last year, while this year that capital is flowing into the bond market.

Market price vs. NAV (premium) for HYG (Bloomberg)

HYG is down 0.6% year-to-date due to this decline in premium, while similar high yield mutual funds that don't have the "premium" issue are up.  For example T.Rowe Price HY Fund (PRHYX) is up 0.8%. What this tells us is that share count is not necessarily an indication of current fund flows into ETFs, particularly when the underlying basket of assets is relatively illiquid. In this aspect ETFs are quite different from mutual funds. More importantly, one should be careful when buying ETFs that trade at a premium, even if the asset class looks attractive.  A mutual fund may be a better alternative.

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Riding the volatility in the junk bond markets

The world of junk bonds (HY) has been particularly turbulent this year. The market not only experienced tremendous volatility, but also saw significant divergence in the performance of  different quality bonds. With risks of global recession constantly circling the markets, investors started gravitating toward higher rated, lower leverage names. In spite of the recent stabilization in the HY market, the "CCC" component continues to lag the higher rated paper.

JPMorgan Domestic HY Index for BB, B, and CCC bonds

The credit market is pricing in some probability of a substantial slowdown in the US that will rapidly increase the debt to earnings ratio for CCC-rated firms, making them vulnerable to default.

But there is another factor driving HY volatility this year. With significant interest in corporate bonds from retail investors, mutual funds and ETFs have been a big driver of supply/demand technical. And investors have been trading that market rapidly, trying to time the rapid “risk on”/”risk off” fluctuations. That translated into erratic inflows and outflows for HY mutual funds on an unprecedented scale as the chart below shows.

This fund flow volatility in the HY markets will continue to whipsaw market participants, exacting pain on those who don’t have the staying power to ride out the Europe-driven market storm.

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Retail investors' love affair with corporate bonds

That's right, a product that was a few years ago reserved for retirees and institutional investors - insurance, pensions (more retirees), etc. is now the darling of retail investors. Institutions and foreigners still hold the bulk of US corporate bonds, but the retail share via mutual funds and ETFs is growing each year (see below in blue).

Source:  Credit Suisse

In fact until recently corporate bond mutual fund assets have been growing rapidly - a trend started in 2009.

Source: Investment Company Institute, Bloomberg

The same trend can be observed in ETFs. A popular corporate bond ETF is the iShares iBoxx Investment Grade Corporate Bond Fund or LQD.  The chart below shows the growth in LQD shares outstanding.

LQD Shares Outstanding (Bloomberg)

So why all this interest in corporate bonds? One key reason is that retail investors continue to shy away from equities.

Brad Barber: My sense is that sentiment for equities isn't going to get positive until the economy is on strong footing. Even though the market has come back, it hasn't really been accompanied by robust economic growth. That can to some degree explain why retail investors remain skittish. The back story of the returns has just not been strong for the last year or two.

So far retail investors have been correct.  Corporate bonds have outperformed equities significantly.  As the chart below demonstrates, on a total return basis (including dividends and interest) LQD has outperformed the S&P500 by some 8% this year.  This outperformance has been caused by falling rates in the US and stagnating equity markets driven by "macro" concerns.  And as long as there is not a full resolution in Europe, this trend may continue.

Total return LQD vs. S&P500 (Bloomberg) 

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The exciting new world of ETFs

The ETF world is becoming more crowded and competitive every day. ETFs have become an extremely popular product with both the individual investors as well as various institutional players. The reasons are plentiful - from instant access to index exposure, to an easy way to enter markets such as China, to a simple way to take a macro view (for example in commodities), or to simply obtain leverage. One of the key reasons institutions love ETFs is liquidity. SPY (S&P DEP RECEIPTS) for example has a trading volume of 100-300 million shares a day, making it one of the most liquid exchange traded instruments in the world. In contrast for example, IBM volume is under 10 million shares a day.

With all this demand, institutions are cranking out new ETF at what seems to be a weekly basis. And each tries to add their bells an whistles to get traction in this competitive landscape. Schwab for example just created a bunch of new equity index ETFs (such as the Schwab U.S. Large-Cap, Small-Cap, etc.), and looking at the ETf universe, one might say zzzzzzzz.... But the spice here is that if you have a Schwab trading account, you can trade these things comission-free -supposedly forever. So if someone allocates a few hundred bucks a month to this strategy, this zero comission offer definitely helps.

But how far are fund companies going to push these products? Well, here is the latest ETF form iShares: ticker symbol ALT. "ALT" stands for alternative investments. That's right, this ETF is a hedge fund. Don't have a few mil to plow into a hedge fund, here is what you can get with the exchange traded ALT:

The objective of the Trust is to maximize absolute returns from investments with historically low correlation to traditional asset classes while seeking to control the risks and volatility inherent in futures and forward contracts by taking long and short positions in historically correlated assets.

Feels, sounds, and might behave like a hedge fund. Here are the 3 strategies ALT manager will trade:

The Trust utilizes investment strategies relating to relative value. Relative value strategies seek to profit from the mispricing of financial instruments, capturing spreads between assets and asset categories that deviate from the fair value or historical norms. The following three general strategies are considered as sources of return:

1. Yield and Futures Curve Arbitrage Strategies
Seek to take advantage of interest rate and futures contract price differentials by simultaneously entering into long and short positions in various bond futures contracts, interest rates futures contracts, commodity futures contracts and/or currency forward contracts that the Trust determines to be mispriced relative to one another. The Trust will enter into long positions in contracts whose underlying assets are deemed relatively inexpensive and will enter into short positions on contracts whose underlying assets are deemed relatively expensive.

2. Technical Strategies — Momentum/Reversal
Seek to take advantage of a comparison between assets' historical returns and their recent performance. Technical strategies are based on the theory that past price history may be predictive of asset value, and so technical strategies may be used to capture returns arising from price changes over time. For example, if recent performance of an asset exceeds historical performance, then a long "momentum" trade opportunity to buy may arise. If the historical performance of an asset exceeds recent performance, then a short "reversal" trade opportunity may arise.

3. Fundamental Relative Value Strategies
Seek returns by attempting to identify instances where there are discrepancies between the market and fundamental values of an asset. Comparing current price to fundamental value may provide a measure of mispricing, or opportunity, which can be compared across markets to provide a metric of relative misevaluation. The Trust's relative value strategies tend to buy in markets that appear inexpensive on a relative basis, and sell in markets that appear expensive, trading long or short positions in the relevant assets.

So if you get bored with US equity index ETFs, or BRIC ETFs, or gold ETFs, of even 3x leverage ETFs, ALT is here to add some hedge fund excitement. But don't bet on this ETF as always being uncorrelated to the equity markets. As we discussed before, correlation can show up in a stressed market with little warning.

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Gold, the new "risk" trade

The risk trade is back on. The markets have taken the happy pill and off to the races we go. The Aussies have raised interest rates and that was a signal that "all is well" again with the world. AUD and equities are on the move, and gold is moving with them.

source: Bloomberg

Yes, gold now trades like a "risk asset" rather than a "safety asset". That means it moves in tandem with equities (which is the opposite of what the relationship used to be). As discussed earlier, the liquid risk trade is the carry trade, the equities trade, and the liquid commodities trade. But we know some US politicians and the CFTC have been on a warpath to limit "speculation" by capping the amount of a commodity one investor can hold. That means that if you are a pension plan and you need to allocate to commodities, be prepared to get your position capped. And those who are over the limit may be forced to liquidate. The same has been the case with some ETFs as our friend Larry recently discovered.

But there doesn't seem to be the same impetus to cap futures positions in gold. The rationale is that high gold prices (unlike high fuel prices) don't hurt anyone. Really? Gold jewelry demand is weakest in almost 20 years and manufacturers, distributors, and stores are struggling. Anyone remember Fortunoff collapse? But their lobby is not strong enough to push for caps, so gold is becoming more of a de facto commodity. GLD, the SPDR gold ETF now holds the amount of gold that is equivalent to half annual global mining supply (some $37 billion worth of gold). It is likely going higher (potentially much higher), with prices and volume in part distorted by likely caps on other commodities.

So welcome to the new risk trade: equities, high rate currencies (against the dollar), and GLD.

Another ETF giving Larry a headache

Having given up on trying to invest in natural gas with USG, Larry (the retail investor) decided to go for a broad commodities index. And why not. The dollar is on a downward path and some commodities exposure could do the old portfolio some good. Larry chose GSG, the liquid iShares ETF that mimics the the Goldman commodities index (S&P GSCI).

But something caught Larry's attention as he was doing his research. From Barclays Global Investors (BGI):

[BGI] has temporarily suspended further creation of new shares of iShares S&P GSCI Commodity-Indexed Trust (the "Trust"). The Trust is listed and trades on the NYSE Arca under the ticker GSG. As disclosed in the Trust's prospectus, a suspension may cause the market price of the Trust's shares to vary more from the Trust's net asset value than historically.

What? Another closed ETF with no more share creation? And what a surprise, it's starting to trade at a premium (the announcement to suspend share creation was on August 24th). GSG is easier to short than USG, so the premium may periodically get taken out, but if the market sees that the share creation will be suspended for a while, the premium may persist.



Larry is now concerned because in addition to taking on the commodity exposure, he's also taking on some CFTC regulatory risk. Plus he may be taking on the risk of GSG/iShares getting dealers to line up a TRS program instead of futures contracts that GSG normally used.

From BGI:

"We are actively working with regulators, product partners and exchanges to explore solutions that will lead to resumption of the creation of new shares of the iShares S&P GSCI Commodity-Indexed Trust to satisfy demand," said Michael Latham, Co-CEO of iShares at Barclays Global Investors. "We've taken this temporary step to protect existing investors from being adversely affected by market reaction to proposed new regulations of commodity futures that have created uncertainty.

So thanks again CFTC. Not only have you stopped Larry and his vicious gang from speculating on natural gas, but you may also be able to keep him from the broad commodity index speculation. Good to know that our commodity markets are protected and supervisory objectives well prioritized.

Fixed income funds show huge return dispersion

Some readers have asked why TLT (iShares 20+ year Treasury Bond ETF) is down 21% year-to-date, even when interest is included. A treasury only fund down this much? In six months? Whoever said treasuries are a "safe" investment?



Has the long bond gotten this much of a beating? Actually it has. The long bond duration was roughtly 13 years (at the beginning of the year) and the yield has moved up by 1.78% (from 2.68% to 4.46%). 1.78% x 13 = 23% loss. Add some interest to that and we are consistent with the TLT move.

Corporate bonds did much better. The investment grade bond ETF LQD is up 4.4% for the year, corresponding to rise in rates and drop in spreads. A really impressive performance came from Bill Gross in the Pimco Total Return Fund (PTTRX), which is up 8.3%. Trading agencies, treasuries, and corporate bonds, these guys were able to rotate in and out of paper to achieve a hedge fund-like return.



Disclosure: long PTTRX