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The Masked Tulip

Etfs Explained... Sort Of...

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Finally got an answer to the ETF question that so many of us have been asking on here in recent months. Um, seems that no one understands them...

BlackRock announced a $13.5 billion merger with Barclays Global Investors today, making the former company the biggest money manager in the world. BlackRock will soon oversee $2.7 trillion in assets, making it roughly twice the size of State Street or Fidelity, its closest competitors. That’s $2.7 trillion under management… with a market cap of just $34 billion.

If that marriage of assets to equity wasn’t unnerving enough, BlackRock will also pick up iShares in the deal. That makes the new world’s biggest asset manager also the world’s biggest wielder of exchange-traded funds (ETFs) — the rabidly popular, complex derivatives (many of which track other complicated derivatives) that millions own, but very few truly understand. Hmmm…

http://dailyreckoning.com/too-big-to-fail-version-20/

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ETFs are not derivatives.

They are. An insurance policy is a derivative. An index fund is a derivative. It is derived from something else. Derivatives have come to mean complex financial instruments with high risk. An exchange traded fund need not be high risk but it is a derivative. Sorry.

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ETFs aren't derivatives. A derivative is a financial instrument that has no intrinsic value, but which derives its value from a legal agreement between the parties to exchange funds based upon the value of an underlying instrument - e.g. the FTSE index. The key point is that the derivative is worth only what the parties are able to pay each other.

An ETF is asset backed. For every tradeable share of the ETF, there exists real shares/metal/etc. held securely by a 3rd party, for which the ETF shares can be freely exchanged (by market makers and other large dealers). In other words, the value of each share of the ETF is governed by the value of the assets held as security, and is not dependent upon anyone's ability to pay someone else.

Edited by ChumpusRex

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They are. An insurance policy is a derivative. An index fund is a derivative. It is derived from something else. Derivatives have come to mean complex financial instruments with high risk. An exchange traded fund need not be high risk but it is a derivative. Sorry.

You may be confusing "synthetic" with "derivative".

For example take my savings, call them a STR fund. I could index this fund by exactly replicating the FTSE, by buying shares. In no way would my indexing my pot of money make it a derivative.

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Guest Steve Cook
ETFs aren't derivatives. A derivative is a financial instrument that has no intrinsic value, but which derives its value from a legal agreement between the parties to exchange funds based upon the value of an underlying instrument - e.g. the FTSE index. The key point is that the derivative is worth only what the parties are able to pay each other.

An ETF is asset backed. For every tradeable share of the ETF, there exists real shares/metal/etc. held securely by a 3rd party, for which the ETF shares can be freely exchanged (by market makers and other large dealers). In other words, the value of each share of the ETF is governed by the value of the assets held as security, and is not dependent upon anyone's ability to pay someone else.

So, are you saying that an ETF's value is derived from the value of something else. That something else being the actual market value of an underlying share?

Sounds like a derivative of some sort to me

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Finally got an answer to the ETF question that so many of us have been asking on here in recent months. Um, seems that no one understands them...

http://dailyreckoning.com/too-big-to-fail-version-20/

ETFs are not complex. They can be invested in derivatives of course, such as CRUD, which mimics holding crude oil by buying futures, but there are others that are invested in a physical product such as PHGP (physical gold).

They are, as the name implies, funds that are tradeable on an exchange, so you can just buy and sell through an ordinary stockbroker account, and the transaction fees are much less than buying into a fund directly.

Edited by bearishbanker

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So, are you saying that an ETF's value is derived from the value of something else. That something else being the actual market value of an underlying share?

Sounds like a derivative of some sort to me

I think the difference is that the underlying asset has been bought, be it shares or commodities. i.e. there is no counterparty risk.

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Guest Steve Cook
ETFs are not derivatives you fondue.

The clue is in the `F`.

I think you are getting hooked up on technical semantics of words.

I understand well enough that "derivatives" are technically not the same as "ETFs". Nevertheless, it is the case, in the normal use of the English language, that ETFs values are not intrinsic to themselves, but are derived from the value of something else. That something else, in the case of commodity ETFs, are futures contracts. These futures contracts themselves, are a type of derivitive in the sense that even you would define such an entity.

Thus, commodity ETF values are derived from derivatives.... :lol:

If I have got this wrong I am happy to have the error pointed out. But, you will need to be specific please.

Edited by Steve Cook

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The problem is that some are and some are not.

An ETF that tracks the FTSE 100 point for point is clearly not a derivative.

Whereas an ultrashort ot ultralong ETF that tracks the FTSE 100 and provides leverages returns in the multiples of the change of the ftse clearly is.

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I have traded numerous ETF's through ETF Securities but have now stopped trading the ones that aren't backed by physical metal as the value of these do not seem to effectively track the commodity. I recently purchased NGAS Natural Gas ETF taking into account the price movement and exchange rate I worked out that I should have made an 11% return but for some reason it only rose 3%. I also purchased COTN Cotton ETF which was more accurate in tracking the price I can only presume that the discrepency is due to the rolling over of futures contracts but not sure how these work.

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Guest Steve Cook
Anything is a derivative, it just means the price derived from something else.

Yes. A thing will have a value in terms of it's exchange value for something else. As soon as you stick an intermediary between you and the thing in question, then that intermediary can be defined as having derived value rather than intrinsic value. Thus, at a fundamental level, money itself can be defined in such terms.

Nevertheless, as soon as ever more distance from an investor and the thing being invested in occurs, problems arise. This is because each extra step allows an extra opportunity for obfuscation and deception

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Guest Steve Cook
I have traded numerous ETF's through ETF Securities but have now stopped trading the ones that aren't backed by physical metal as the value of these do not seem to effectively track the commodity. I recently purchased NGAS Natural Gas ETF taking into account the price movement and exchange rate I worked out that I should have made an 11% return but for some reason it only rose 3%. I also purchased COTN Cotton ETF which was more accurate in tracking the price I can only presume that the discrepency is due to the rolling over of futures contracts but not sure how these work.

backwardation and contango in futures contracts I think

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ETFs are not derivatives.

Some very interesting discussions on ETF's below.

My own thoughts;

1. ETF's are indeed very derivative.

2. The ETF market is now so big, and so liquid, that the ETF tail is wagging the underlying commodities to behave even more irrationally than commodity markets already behave. So more bigger falls and spikes, less related to underlying (eg. current record levels of oil storage concurrently with dramatic spike in prices).

3. If one of the issuers gets caught out on the wrong side of one of these spikes then they could easily be another Lehman / AiG.

4. Just how much QE money has been funnelled off into the ETF / commodity nexus?

5. ETF's, the new CDS? Except that Joe Public gets to play with ETF's.

http://europe.theoildrum.com/node/5496#more

Could $30/bbl Oil Happen Before New Year’s Eve?

As a result of these forces, I believe that there is a substantial chance that oil prices may again experience a rapid drop to perhaps as low as $30 barrel before Christmas. One reason I believe this is likely is based on my research with respect to US Oil Fund USO. In February USO held 100 000 WTI contracts (1 contract = 1 000 bbls), but this had dropped to 50 000 WTI contracts recently, as ETF purchasers increasingly switched to Natural Gas. Strange as it may seem, the sale of these USO contracts may be part of what is holding WTI prices up, and natural gas prices down. As the number of WTI contracts reaches a minimum, this influence may turn around the other way.

Alphaville, in the post The problem with commodity ETFs, explains the apparently strange price relationship that I mentioned in the introduction, where a sale of ETFs seems to result in a rise in prices of a commodity, and the purchase seems result in a fall in prices. This seems to be related to the fact that ETFs, because their market positions are so large, cannot hold their entire positions in commodity contracts. Instead, they hold a majority of their position on over-the-counter swaps. Changes in these positions behave differently than one would expect.

http://ftalphaville.ft.com/2009/06/11/5693...-commodity-etfs

The problem with commodity ETFs

ETFs [based]on Commodity Futures have a basic design flaw in that they are open-ended fund that invest in assets (Futures) that are close-ended (either due to CFTC regulation or due to lack of liquidity). This is a major contradiction that is at the source of market dysfunctions.

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