With more than a hat tip, but a full bow to my reader Eric, I present a recent comment of his:
Eric Says: Regarding your existing portfolio, you’ve sometimes held FXF and other Proshares Currency funds. Based on the following excerpt, does it seem to you that these funds are too dependent upon the solvency of JP Morgan?
“The Trust has no proprietary rights in or to any specific Swiss Francs held by the Depository and will be an unsecured creditor of the Depository with respect to the Swiss Francs held in the Deposit Accounts in the event of the insolvency of the Depository or the U.S. bank of which it is a branch. In the event the Depository or the U.S. bank of which it is a branch becomes insolvent, the Depository’s assets might not be adequate to satisfy a claim by the Trust or any Authorized Participant for the amount of Swiss Francs deposited by the Trust or the Authorized Participant, in such event, the Trust and any Authorized Participant will generally have no right in or to assets other than those of the Depository. In the case of insolvency of the Depository or JPMorgan Chase Bank, N.A., the U.S. bank of which the Depository is a branch, a liquidator may seek to freeze access to the Swiss Francs held in all accounts by the Depository, including the Deposit Accounts. The Trust and the Authorized Participants could incur expenses and delays in connection with asserting their claims. These problems would be exacerbated by the reality that the Deposit Accounts will not be held in the U.S. but instead will be held at the London branch of a U.S. national bank, where it will be subject to English insolvency law. Further, under U.S. law, in the case of the insolvency of JPMorgan Chase Bank, N.A., the claims of creditors in respect of accounts (such as the Trust’s Deposit Accounts) that are maintained with an overseas branch of JPMorgan Chase Bank, N.A. will be subordinate to claims of creditors in respect of accounts maintained with JPMorgan Chase Bank, N.A. in the U.S., greatly increasing the risk that the Trust and the Trust’s beneficiaries would suffer a loss.”
I have written about credit risk of ETNs before, but now I have to write about credit risks of ETFs. When an investment consists of foreign currency bank deposits of a single bank, there is a concentrated credit risk. In this case, the credit risk is to JP Morgan’s London branch. A default could be messy, with different laws in the UK.
This just highlights the risk involved with esoteric asset classes, where the “cheap” way of getting the exposure comes through credit or derivative agreements. Be wary as you consider unique ETFs and ETNs; there can be credit risks that you have not considered.
thank you Eric and David. I have been wondering how to hedge against the dollar, but have avoided ETF’s because it just didn’t feel right.. Now i know why.
WHile the ETF is a hedge against the currency, it is not a hedge against a system blowup. And given what we have seen, that is not good enough.
So, what are the other possibilities for a normal US citizen to hedge against a dollar collapse? David? Eric? anyone?
I think the easiest and most straightforward would be purchasing foreign currency futures contracts on an exchange such as the CME. http://www.cme.com
When I was studying the fine print of ETFs in Europe I’ve noticed the tendency to “enhance” them via swaps.
Lets take a simple example from the DB report.
http://www.dbxtrackers.co.uk/pdf/EN/semiannualreport/semiannualreportLU0292109344_2008_06.pdf
DB is in Europe, these funds are offered to Europeans, so how about the simplest of funds (Page 11):
“db x-trackers DJ EURO STOXX 50® ETF
===================================
Investments at market value 968,567,156
Cash at bank 679,049
[...]
Unrealised loss on swap 4,177,966
[...]
TOTAL NET ASSETS 964,264,558″
What does the ETF hold? Surely European stock, no? (Page 33)
“Shares Japan
Aeon Co. Ltd. 1,871,280 JPY 14,772,493 14,688,686 1.52
Astellas Pharma Inc. 1,164,608 JPY 31,337,764 31,378,613 3.25
Dai Nippon Printing Co. Ltd. 1,069,762 JPY 9,963,760 10,024,044 1.04
Daikin Industries Ltd. 316,844 JPY 10,633,689 10,168,379 1.05
Dainippon Sumitomo Pharma Co. Ltd. 919,693 JPY 4,632,642 4,730,178 0.49
Denso Corp. 1,424,566 JPY 31,817,089 31,132,708 3.23
[...]”
Not a single European company! There is a note to swaps involved (Page 102)
“The table below lists the notional value of both the paying and receiving legs of the swap and the unrealised gain /
(loss) on swap per Sub-Fund.
db x-trackers DJ EURO STOXX 50® ETF EUR 983,521,991 (4,177,966)”
I don’t understand why DB is allowed to gamble with investors money like this (all other listed ETFs are constructed similarly). Sure, it is unlikely that you go to zero when DB goes down, as there actually ARE some Japanese shares in the ETF. But it does not smell like a square deal to me either.
Anything like this seen in US stock ETFs? Who are the worst offenders?
(Btw: thanks. I’ve read Erics quote from the prospectus a year ago but did not understand it. Sold all my FXY yesterday.)
David, considering how many times such funds have been discussed and recommended on websites like theStreet.com, I think that it would be neat if you proposed contributing a brief piece about it over there. Seriously, it’s the kind of thing that they would actually love because it stands to get some buzz going. I’ll bet there are literally hundreds of lay investors who hold such funds and would benefit from such an article. (And you can take the credit!!!!)
David: Would like your ideas on the credit risks of the ultra funds, both long and short. Over at Barry Ritholtz, Big Picture, the subject has come up intermittently, but the prospectuses are suitably vague, allowing them to invest in options, swaps and such, but giving no info on how much they put into each.
Thanks.
IF: I bought a foreign bond fund for my wife’s 403b. The reports on Schwab looked ok. Later, on Morningstar, it showed that they owned a bunch of swaps on one of the foreign currencies. Believe it was the Yen.
I used to own PIMCO Commodity Real Return (D). Reading the statement of holdings, it always bothered me the garbage they held in there for yield enhancement. They said it was a “double real return strategy” to hold TIPS and commodity index swaps. That’s what I wanted. I did not want to be writing CDS on Peruvian sovereign debt.
“Credit risk, it’s what’s for dinner.”