Friday, June 17, 2016

Things You Don't Want to Know about ETFs and ETNs

Everybody loves trading or investing in ETPs. ETP is the acronym for exchange-traded products, which include both exchange-traded funds (ETF) and exchange-traded notes (ETN). They seem simple, transparent, easy to understand. But there are a few subtleties that you may not know about.

1) The most popular ETN is VXX, the volatility index ETF. Unlike ETF, ETN is actually an unsecured bond issued by the issuer. This means that the price of the ETN may not just depend on the underlying assets or index. It could potentially depend on the credit-worthiness of the issuer. Now VXX is issued by Barclays. You may think that Barclays is a big bank, Too Big To Fail, and you may be right. Nevertheless, nobody promises that its credit rating will never be downgraded. Trading the VX future, however, doesn't have that problem.

2) The ETP issuer, together with the "Authorized Participants"  (the market makers who can ask the issuer to issue more ETP shares or to redeem such shares for the underlying assets or cash), are supposed to keep the total market value of the ETP shares closely tracking the NAV of the underlying assets. However, there was one notable instance when the issuer deliberately not do so, resulting in big losses for some investors.

That was when the issuer of TVIX, the leveraged ETN that tracks 2x the daily returns of VXX, stopped all creation of new TVIX shares temporarily on February 22, 2012 (see sixfigureinvesting.com/2015/10/how-does-tvix-work/). That issuer is Credit Suisse, who might have found that the transaction costs of rebalancing this highly volatile ETN were becoming too high. Because of this stoppage, TVIX turned into a closed-end fund (temporarily), and its NAV diverged significantly from its market value. TVIX was trading at a premium of 90% relative to the underlying index. In other words, investors who bought TVIX in the stock market by the end of March were paying 90% more than they would have if they were able to buy the VIX index instead. Right after that, Credit Suisse announced they would resume the creation of TVIX shares. The TVIX market price immediately plummeted to its NAV per share, causing huge losses for those investors who bought just before the resumption.

3) You may be familiar with the fact that a β-levered ETF is supposed to track only β times the daily returns of the underlying index, not its long-term return. But you may be less familiar with the fact that it is also not supposed to track β times the intraday return of that index (although at most times it actually does, thanks to the many arbitrageurs.)

Case in point: during the May 2010 Flash Crash, many inverse levered ETFs experienced a decrease in price as the market was crashing downwards. As inverse ETFs, many investors thought they are supposed to rise in price and act as hedge against market declines. For example, this comment letter to the SEC pointed out that DOG, the inverse ETF that tracks -1x Dow 30 index, went down more than 60% from its value at the beginning (2:40 pm ET) of the Flash Crash. This is because various market makers including the Authorized Participants for DOG weren't making markets at that time. But an equally important point to note is that at the end of the trading day, DOG did return 3.2%, almost exactly -1x the return of DIA (the ETF that tracks the Dow 30). So it functioned as advertised. Lesson learned: We aren't supposed to use inverse ETFs for intraday nor long term hedging!

4) The NAV (not NAV per share) of an ETF does not have to change in the same % as the underlying asset's unit market value. For example, that same comment letter I quoted above wrote that GLD, the gold ETF, declined in price by 24% from March 1 to December 31, 2013, tracking the same 24% drop in spot gold price. However, its NAV dropped 52%. Why? The Authorized Participants redeemed many GLD shares, causing the shares outstanding of GLD to decrease from 416 million to 266 million.  Is that a problem? Not at all. An investor in that ETF only cares that she experienced the same return as spot gold, and not how much assets the ETF held. The author of that comment letter strangely wrote that "Investors wishing to participate in the gold market would not buy the GLD if they knew that a price decline in gold could result in twice as much underlying asset decline for the GLD." That, I believe, is nonsense.

For further reading on ETP, see www.ici.org/pdf/per20-05.pdf and www.ici.org/pdf/ppr_15_aps_etfs.pdf.

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Industry Update

Alex Boykov co-developed the WFAToolbox – Walk-Forward Analysis Toolbox for MATLAB, which automates the process of using a moving window to optimize parameters and entering trades only in the out-of-sample period. He also compiled a standalone application from MATLAB that allows any user (having MATLAB or not) to upload quotes in csv format from Google Finance for further import to other programs and for working in Excel. You can download it here: wfatoolbox.com/epchan.

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31 comments:

Lauri Suoranta said...
This comment has been removed by the author.
Lauri Suoranta said...

(Leveraged) ETFs may also have excessive tracking errors. I have not done any systematic study, but briefly examined an ETF titled "ETFS 2X Daily Long WTI Crude Oil" (ticker 4RT6 in XETRA). In one year period from spring 2015 to spring 2016, the underlying non-leveraged index closed at roughly the same level, but the ETF shares (or NAV per share) lost about three quarters. Bloomberg currently puts 1yr return at -73.74%, taking into account a reverse split. Most of that loss cannot be explained by the fact that the ETF is supposed to replicate daily leveraged returns. Based on this, it is essential to have long-term data on how an ETF has performed against the (simulated) index, although some ETFs like physical gold funds (of reasonable size) can probably be safely assumed to track it quite faithfully. Of course, it is also important to remember the difference between daily and long-term returns, as pointed out in the post.

Anonymous said...

Hi Ernie,

What kind of price do you use to calculate P/E ratio in backtesting, adjusted or unadjusted?

Thanks.

Ernie Chan said...

Typically earnings per share was not adjusted, hence one must use unadjusted price as well.
Ernie

Anonymous said...

Hi Ernie,

Thank you for quick response.

But for stocks split, there would be big change in unadjusted price, so P/E ratio in backtesting. How do we deal with that?

Thanks.

Ernie Chan said...

If both earnings and prices are unadjusted, their ratio is invariant with respect to any splits or dividends.

Ernie

Ernie Chan said...

I should clarify that by "earnings", I meant "earnings per share".
Ernie

Anonymous said...

Hi Ernie,

However, it seems earnings per share just updates quarterly, but price updates every day.

There would be a gap window between them. Thanks.

Ernie Chan said...

Whenever there is a split, earnings per share will change in the same % as market value per share (i.e. market price). Earnings per share won't just update quarterly in this situation.

Ernie

Anonymous said...

Hi Ernie,

Can we get pre-open quotes for US stocks via IB data feed?

Thanks.

Ernie Chan said...

Sure we can!

Ernie

Anonymous said...

Hi Ernie,

Is that easy to buy mid-cap US stocks at open prices?

Thanks.

Ernie Chan said...

If you send in a Market On Open order, you are guaranteed to get filled at open price, unless you are buying millions of shares.

Ernie

Anonymous said...

Hi Ernie,

If we send in a Market On Close order, are we guaranteed to get filled at close price?

Thanks.

Ernie Chan said...

Yes, you are.
Ernie

Anonymous said...

Hi Ernie,

In your second book, you talk about interday momentum strategies, and you mention a "Time series momentum" paper written by Moskowitz, Yao, and Pedersen, 2012.

I find that in their paper, they use "excess return" to build the momentum strategy.

Do you know what is the definition of "excess return" in their paper?

Thanks.

Ernie Chan said...

Excess returns mean returns minus risk free rate.

Ernie

Anonymous said...

Hi Ernie,

Would you please recommend some papers about order book trading strategies?

Thanks.

Ernie Chan said...

Please see the book by Cartea et al. on Algorithm and High Frequency Trading on my Recommended Books list on the right sidebar.

Ernie

Anonymous said...

Hi Ernie,

Do you trade "join the bid" high-frequency strategy in your book for futures?

Thanks.

Ernie Chan said...

No, we haven't tried that yet.
Ernie

Anonymous said...

Hi Ernie,

Are all US bond futures pro-rata matching?

How do we know they are pro-rata matching?

Thanks.

Ernie Chan said...

To my knowledge, only Eurodollar futures has pro-rata matching on CME. You should watch the talk by Dr. Edith Mandel at QuantCon 2016. It was an amazing talk on trading the ED market.

Ernie

Anonymous said...

Hi Ernie,

Sounds great!

Where can we watch "Quantitative Trading in the Eurodollar Futures Market" by Edith Mandel?

Thanks

Ernie Chan said...

It would be best if you direct this question to QuantCon's organizer Quantopian.com.

Ernie

Anonymous said...

Hi Ernie,

If we send MOO in IB TWS, could we save bid-ask spread?

How does IB handle MOO?

Thanks.

Ernie Chan said...

Sure, MOO order is executed during the closing auction. Nobody pays bid-ask spread.
IB or any broker will just route it to the exchange for this auction. But note that you need to submit this order 10 minutes or more ahead of the close (based on NYSE or Nasdaq rules).

Ernie

Ernie Chan said...

QuantCon has given me these special links for our readers here:

"Quantitative Trading in Eurodollar Futures Market" by Edith Mandel:
Video https://vimeopro.com/user7561422/quantcon-2016-videos/video/164045995 (Enter password: WeLoveQuantsQ2016!)
Slide Presentation https://www.slideshare.net/secret/se7g2urie9h3xp

Enjoy!
Ernie

Anonymous said...

hi Ernie,

In Kalman filter, in the state equation, I find there are two kinds of version in references, they are

m(t) = m(t-1) + w(t-1), and
m(t) = m(t-1) + w(t),

I am confused here.

Do you know the difference between them?
Thanks.

Ernie Chan said...

w is a Gaussian noise term. There is no time series model for how it evolves, and you can consider it as serially uncorrelated. Hence it doesn't matter whether you use w(t) or w(t-1).

Ernie

Anonymous said...

Hi Ernie,

Thank you for quick response.

However, in m(t) = m(t-1) + w(t-1),

at time t, w(t-1) is realized, not random anymore, which is weird.

I prefer m(t) = m(t-1) + w(t), making more sense, time index of white noise should be consistent with that of dependent variable.