Investors Should Beware Of ETFs That Use Derivative Contracts (UNG, FAZ)

August 18, 2009 9:39am ETF BASIC NEWS NYSE:FAZ

buyer-beware“Investors should beware of the increasing number of ETFs that use derivative contracts to achieve investment objectives. While the use of swaps has helped many ETF


 issuers provide investors with exposure to previously inaccessible regions of the market, these ETFs layer another dimension of risk onto already-concentrated investment objectives,”  Don Dion Reports From The Street.

“Before investing in ETFs like U.S. Natural Gas (UNG) or Direxion Daily Financial Bear 3X (FAZ), investors must understand the counterparty risk involved in achieving these fund objectives. Traditional ETFs track an underlying index and are representative of a basket of stocks. The iShares Dow Jones U.S. Financial Sector Index Fund (IYF), for example, tracks the Dow Jones U.S. Financials Index, essentially a basket of the stocks like JPMorgan Chase (JPM) and Bank of America (BAC). Investors can simply visit the fund’s website to see how many shares of each financial firm are represented in the overall ETF,” Dion Reports. 
 
“Ultra and leveraged ETFs use traditional indices plus swaps to achieve an investment objective. The ProShares UltraShort Financials ETF (SKF) also uses the Dow Jones U.S. Financials Index. Instead of tracking a basket of stocks, SKF tracks a combination of financial instruments such as futures and swaps,” Dion Reports.

The prospectus for SKF describes swaps as complex instruments with counterparty risk:

“Swap agreements are two-party contracts entered into primarily with institutional investors for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the returns…. The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.”

Chart for Direxion Daily Financial Bear 3X Shares (FAZ)

Chart for United States Natural Gas (UNG)

Full Story: HERE

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