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Thread: Question about trading ETFs

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    Default Question about trading ETFs

    So I am positioned in inverse ETFs like SDS and FXP to profit from the next leg down in the market. BUT my worry is what happens to my investments in ETFs if the counterparty (financial institution that manages the ETF) fails! Will my profit be wiped out even if the market does go down?

    Look what I found regarding currency ETFs:

    September 18, 2009 (MarketWatch)

    "Rydex's lineup of currency ETFs includes several funds with total assets in the range of $500 million, such as CurrencyShares Euro Trust, CurrencyShares Australian Dollar Trust , CurrencyShares Canadian Dollar Trust and CurrencyShares Japanese Yen Trust .

    The ETFs are structured as grantor trusts and have expense ratios of 0.4%, and investors need to pay broker commissions to trade ETFs, since they are bought and sold like individual stocks.

    They hold foreign currencies in overseas interest-bearing accounts, and their value is determined by the movement of that currency versus the U.S. dollar. The Rydex currency ETFs also pay a yield that is tied to local interest rates, minus fees. CurrencyShares pay interest income on a monthly basis, which is taxed as ordinary income. Meanwhile, any short-term or long-term gains in the ETFs due to currency moves are taxed at the ordinary rate up to 35%.

    Morgan Stanley's Maister pointed out that investors in the CurrencyShares ETFs do not have FDIC insurance and therefore assume the credit risk of the depository bank, J.P. Morgan Chase .


    So should JPM fail, and all that money that is short dollar in the ETFs above is wiped out, will it be supportive for the dollar?

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    Default Re: Question about trading ETFs

    Also, what would it do to the price of physical gold should GLD fail?

    here are a few important pointers, but the whole article is worth reading!

    http://www.marketoracle.co.uk/Article9030.html

    "GLD failure to allow redemptions in gold is suspicious. In fact, only two gold ETFs worldwide allow redemptions in gold, and both of them are located in Switzerland: Gold ETF from Zurich Kantonalbank (ZKB) and Julius Baer (JBGOUA). "

    " I recommend GLD investors re-read its perspectus, as the ETFs loose legal framework and counterparty risks are clearly outlined. The SPDR Gold Shares Prospectus states that GLD ”is subject to a number of risks and uncertainties, including, but not limited to:”

    fluctuations in the price of gold;
    reductions in the amount of gold represented by each Share due to the payment of Trust expenses and the impact of the termination of the fee reduction under the Trust Indenture;
    purchasing activity in the gold market associated with the purchase of Baskets from the Trust;
    the lack of experience of the Sponsor and its management in operating an investment vehicle such as the Trust; unanticipated operational or trading problems;
    the lack of protections associated with ownership of shares in an investment company registered under the Investment Company Act of 1940 or the protections afforded by the Commodity Exchange Act of 1936;
    the lack of a market for the Shares;
    the level of support from the World Gold Council;
    competition from other methods of investing in gold;
    the impact of large-scale distress sales of gold in times of crisis;
    the impact of substantial sales of gold by the official sector; the effect of a widening of interest rate differentials between the cost of money and the cost of gold;
    the loss, damage, theft or restrictions on access to the Trust's gold; [restrictions?]
    the lack of adequate sources of recovery if the Trust's gold is lost, damaged, stolen or destroyed, including a lack of insurance;
    the failure of gold bullion allocated to the Trust to meet the London Good Delivery Standards;
    the failure of sub-custodians to exercise due care in the safekeeping of the Trust's gold; [ie: leasing out gold (which is allowed per perspectus)]
    the limited ability of the Trustee and the Custodian to take legal action against sub-custodians; [GLD is designed to protect sub-custodians from the legal action which losses on their gold leasing activity would trigger]
    the insolvency of the Custodian; [As noted in GLD's prospectus, we know “Gold held in the Trust's unallocated gold account and any Authorized Participant's unallocated gold account will not be segregated from the Custodian's assets. If the Custodian becomes insolvent, its assets may not be adequate to satisfy a claim by the Trust or any Authorized Participant.
    ]
    the Trust's obligation to reimburse the Purchaser and the Market Agent for certain liabilities in the event the Sponsor fails to indemnify them;
    competing claims over ownership of intellectual property rights related to the Trust;
    other factors identified in the “Risk Factors” section of the Prospectus filed with the SEC and in other filings made by the Trust from time to time with the SEC. "

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    Default Re: Question about trading ETFs

    and this, from the same article:

    http://www.marketoracle.co.uk/Article9030.html

    "Metals bought from the government-backed financial institutions have an especially high risk of confiscation."!!!

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    Default Re: Question about trading ETFs

    You correctly point out that many Exchange Traded Funds are really shares in 'paper promises'.

    SHORT Index ETF's like SDS are really a collection of S&P stock share shorts, options, futures etc. - in other words, 'derivatives' that have no intrinsic 'value' and are thus dependent on a counterparty to 'pay off'.

    LONG Currency ETF's like FXY do actually own foreign currencies (in this case Yen). In that sense, they do represent intrinsic 'value' ( well, to the degree that the underlying currency has intrinsic 'value' anyhow). But depending on the particular ETF's charter, actual currency ownership may only comprise a portion of the fund's holdings - with the balance being currency futures or other 'derivatives'.

    LONG Commodity ETF's, like certain currency ETF's, may also be a mixed bag of ownership of the commodity itself, plus commodity futures and other 'derivatives'.

    In the case of GLD, the ETF itself owns and stores a lot of physical gold. But ETF share owners do not actually own a share of this physical gold - merely shares in the 'company'. This is the reason for the disclaimer about no right to payment in gold.

    As to the other disclaimers, some reflect back to Roosevelt era laws which are still on the books, and which essentially provide the US gov't with the right to an 'emanent domain' purchase of all gold within the USA / owned by US citizens at a price 'set' by the same US gov't. Back in the 30's, this gov't power was used to buy up all gold in private hands at a price of US$20.67 ... and in turn to 'revalue' the US dollar versus gold price to US$35 per ounce so that foreign gov't creditor claims could be satisfied with far fewer ounces of gold. In essence, the US gov't made a $14.33 'profit' on every ounce of gold it 'confiscated', while the former gold owners took a $14.33 notional 'loss'. But in the final analysis this was really not very different from the 1930's holders of US dollars simultaneously taking a 30% reduction in the international 'purchasing power' of those US dollars ! However, back then, typical US citizens were far less dependent on international trade / commodity prices as far as routine household purchases / bills were concerned - and as such the US dollar devaluation drew very little attention outside of banking / investing / corporate / gov't circles.

    Obviously, today's gold owners are wary that the same gov't authority could again be invoked, thus the notional 'profits' from their gold ownership could again be 'confiscated' by the gov't. And unlike the 30's, today's gold owners have generally left a wide paper trail for the gov't to follow in tracking down that gold. This is the point behind your last link.

    And to your last point - US 'securities' are insured against FRAUD by the SIPC. The SIPC does NOT insure against loss. And even though currency ETF's ( and certain money market funds) may hold US dollars in a manner superficially analogous to banks, ownership of those currency ETF ( and certain money market fund) shares still represents ownership of a 'security'. But on the flip side, even though US bank account deposits ( and certain other money market accounts) are insured against LOSS by the FDIC, like the AIG experience that insurance payout is only as 'good' as the insurance company's reserves. At the moment the FDIC is essentially broke due to the previous bank failure payouts, and is at this very moment exploring contingency plans that would allow it to cover losses from future bank failures (i.e. accelerated FDIC insurance premium collections from solvent banks, line of credit from the US Treasury etc.)

    ~
    Last edited by Melonie; 09-29-2009 at 02:18 AM.

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