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February 25, 2009 — Issue #412
  
Article

There is Danger in Holding ETFs Long Term by Van Tharp

Trading Education

Spring Training

Trading Tip

Two Super Smart Guys – Same Bearish Conclusion by D.R. Barton

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Risk and Expectancy Are Not Directly Related

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Feature

There is Danger in Holding ETFs Long Term
by
Van K. Tharp, Ph.D.

In my big picture assessment, I look at the world markets by looking at the performance of various ETFs that represent the markets. And I used to believe that ETFs were great trading vehicles to own long term. However, it’s recently come to my attention that sometimes ETFs do not actually own what they are represented to own and that could be very dangerous to your wealth in this economic climate. In fact, some of them might be a lot like derivatives. It’s great if you own derivatives and they move in your direction, but it’s worthless if the party that wrote the derivative in the first place cannot honor its end of the bargain. Our job at the Van Tharp Institute is financial education:

  • Psychology of trading

  • Business planning as a trader

  • Worst-case contingency planning (which we’ve helped countless traders master through our Blueprint workshop.)

  • System development and

  • Position sizing to meet your objectives.

The following warning, about ETFs in general and GLD in particular, falls under the heading of worst-case contingency planning. There are many traps in this economic climate that you need to be aware of. This one has only just come to my attention.

Let’s look at the case for GLD as an example.1 If you own this ETF, you probably know that it is somewhat like owning gold…and some people think it is the same as owning gold bullion. But there is a big difference. Theoretically the GLD Trust owns 850 tons of gold, but it might not really own that much gold. In fact, it might not have much real gold at all.

Why? Well, in the GLD Trust Prospectus (November 2004) you will find that it has no way of really guaranteeing how much gold it does own. In truth, GLD has no way of knowing whether the gold that is held in trust for it is actually there or not. It could be that the bank that is holding it already has it leased out. In other words, banks could be playing the same game with gold that they do with your money. They hold your money on deposit, theoretically, but most of it is given out in loans. And what happens if the bank that is leasing out your gold fails? Do you think the government will bail them out so that you get your gold back? What if they actually tell you in the Prospectus that there is substantial risk involved and that it is much more substantial than a drop in the price of gold?

People have been worried about the government confiscating gold. But what would happen if 850 tons of gold (about $25 billion worth) suddenly disappeared? I’m not sure, but the disappearance of $25 billion worth of it would certainly be a blow to the financial system.

GLD, and I’m just using this as an example of what might be the case with other ETFs, has no way to legally determine if the gold being kept by the custodian (which is the European bank HSBC) is actually in the Custodian’s vault. HSBC has the right to use other banks as "subcustodians" to keep the gold safe. And those subcustodians could actually use other subcustodians of their own.

The way GLD is set up, there is a series of legal barriers that prevent anyone from verifying if the gold is in the vault or leased out. Thus, GLD could have nothing to actually back up the 850 tons of gold it claims to have. Is GLD another financial Ponzi scheme, but with good intentions?

The Prospectus

The ability of the Trustee to monitor the performance of the Custodian may be limited because under the Custody Agreements the Trustee may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust's gold and certain related records maintained by the Custodian (p. 37).

The Trustee and auditor are not allowed to visit the Custodian “when no gold of the Trust is held in the Custodian's vault.” (p. 48). And this could occur when it is being held by subcustodians. Thus, the Trustee of GLD has a limited ability to determine what the Custodian is doing and no ability to determine what the subcustodians (at any level) are doing. “The Custodian is not responsible for the actions or inactions of subcustodians.” (p. 44) And the Trustee has no right to audit the gold or even any financial records about the gold of the subcustodians. 

“In addition, the Trustee has no right to visit the premises of any subcustodian for the purposes of examining the Trust's gold or any records maintained by the subcustodian, and no subcustodian is obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian." (p.37).  Furthermore, the Prospectus states that “because neither the Trustee nor the Custodian oversees or monitors the activities of subcustodians who may hold the Trust's gold, failure by the subcustodians to exercise due care in the safekeeping of the Trust's gold could result in a loss to the Trust.” (p. 12).

Current subcustodians appear to be one US bank: JP Morgan (which has $US93 trillion in derivative exposure).

One Canadian Bank: The Bank of Nova Scotia.

And four European banks: the custodian, The Bank of England, Deutsche Bank AG, and UBSAG.

All of these banks actively lease gold.

However, it gets worse. The GLD trust does not insure its gold. According to the Prospectus, only the Custodian is responsible for insurance and “shareholders can not be assured that the Custodian will maintain adequate insurance” (p. 11). Furthermore, “Custodian and the Trustee will not require any direct or indirect subcustodians to be insured or bonded” with respect to gold held by the subcustodians on behalf of the Trust (p. 11). “Consequently, a loss may be suffered with respect to the Trust's gold which is not covered by insurance and for which no person is liable in damages” (p. 11). If subcustodians are used outside of the U.S., it may be difficult or impossible to seek legal remedy against the subcustodians (p. 12). This is significant because the Custodian's primary vault is in London. The subcustodians' vaults can be anywhere in the world.

A further source of risk is the possible insolvency of the Custodian, HSBC. How solvent do you think banks are these days? And if the subcustodians fail to return any gold that they have to the HSBC, there is no contractual obligations that can be enforced.

According to Tom Dysan in Daily Wealth on Monday Feb 23rd, the European banking system is about to collapse. And it is this banking system that holds the gold in the GLD Trust. The Daily Telegraph reports that European banks may have to write off $25 trillion in comparison to the $1.8 trillion written off by U.S. banks. This is because they have lent aggressively to Emerging Europe, which has imploded and been even more aggressively involved in the subprime debacle than their U.S. counterparts. Furthermore, they have no printing press like the Federal Reserve to print trillions of Euros to exchange for the junk debt like the U.S. has.

Lastly, banks and corporations have been geniuses at hiding what they are doing from the public. Greenspan said, “I always believed that banks would police themselves to control risk.” However, my impression of most banks is that they don’t even understand risk. They’ve had rogue traders costing them a billion dollars a year. They've basically built up derivative exposures that equal many times the wealth of the world (only a small percentage of which has imploded so far). And, they've basically created much of the financial mess we are in today. They are also closely tied to the politics of most countries. For example, who was at the Swiss Conference at Davos to solve the world’s financial problems? It was politicians, bankers, and some of the world’s richest people. So do you trust banks to look after your gold that you might have through GLD? I wouldn’t.

GLD is probably fine for short term trading. However, for holding long term positions, it could become a disaster. And if one of the most well known ETFs is organized this way, it suggests that you should really look at the prospectus of any other ETF that you plan to hold for any length of time… especially under the current economic conditions.

1. This information was first pointed out to me in an article written by Dave Kranzler posted in a blog: http://www.rapidtrends.com.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com. 

 

Trading Education

Spring Workshop Schedule

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April 24-26  Blueprint for Trading Success
April 28-30  Peak Performance 101
May 11-13  How to Develop A Winning Trading System
May 15-17  Exchange Traded Funds 101
May 18-19  ETF 202 (Two day workshop Add-on)

Learn More...

Trading Tip

Two Super Smart Guys – Same Bearish Conclusion

by
D.R. Barton

 

Many people are looking for us to find a bottom to the huge swoon the market has suffered since it made a top in October of 2007.  Lots of pundits and talking heads (but fewer analysts) predicted that the low was last November.  This week, they were proved wrong.

So the question on so many traders’ and investors’ minds is, “When will the drop end?”  People are looking for a return to “normalcy” (whatever that means).  For most folks that insinuates a return to a bull market.  For others, they would certainly be satisfied with an end to double digit down quarters.

Van is on record as being a long term bear, based on his analysis of where the market is relative to very long term market cycles.  And today I’ll talk about two other very smart guys who have a dim view of the near term direction of the economy and markets.

But don’t fret—this is not all gloom and doom.  At the end of the article we’ll talk about elements of a game plan for traders and investors as long as the market continues its downward bias.

George Soros and Ray Dalio – More Bearish Fuel for the Fire

When folks like George Soros speak publically, we need to make sure that we filter the comments through his potential biases politically and as an investor.  But one thing’s for sure, there’s been no better trader over the last half a century.  So his comments certainly warrant our attention.  Speaking about the financial sector at Columba University last Friday, Soros said that “There’s no sign that we are anywhere near a bottom.”

Fewer people know the name Ray Dalio. He’s the head of Bridgewater Associates and is one of the most savvy hedge fund managers on the planet with over $80 billion dollars in assets.  In a recent interview in Barron’s he talked about this economy moving from recession into depression.  Though he chose not to use that word, speaking instead in the euphemistic term “d-process.”  In short, Mr. Dalio believes that we are seeing financial problems that are unlike anything seen in the post World War II era.  He cites known issues such as an exploding Fed balance sheet, zero interest rates, deflation and bank stocks losing so much value that many are not viable in their current state.  His bottom line though is that the relatively quick fixes that have worked in the U.S. in the last six decades can’t be counted on this time around.  For precedence on what’s happening we have to look to Japan in the 1990s and Latin America in the 1980s—crises that took longer than a decade to resolve.

But There IS Opportunity!

The markets aren’t just a gloom and doom story, though. Any time there is this much movement in the markets, there is opportunity.  That is certainly true for short term traders.  But even for those with a longer term outlook, there will be opportunities.  We all just need to realize that buy and hold is a dead model and get over it.  Even in the worst bear markets, there are protracted periods of powerful rallies.  Traders and investors will need to adopt their strategies to be more nimble.  Holds of months instead of years will be the norm for long term investors until the financial system stops leaking oil.  And opportunistic  smaller company plays will most likely prove more fruitful than playing the behemoths.  Institutions will continue to look for stocks that are less correlated to the markets movements, and to stocks that have greater beta than the overall market so that they can bump up their returns when they’re right.  Individual investors will be prudent to do the same.

Great Trading,

D. R.

About D.R. Barton:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  “drbarton” at “iitm.com”.  

Mailbag

Risk and Expectancy Are Not Directly Related

Q:  I recently received my copy of Definitive Guide to Position Sizing. I've begun reading it, am finding it rewarding, but have some concerns about expectancy as explained on pages 14 to 19. 

1) In table 2-2, in several instances loss exceeds risk. For example, $800 risked but $2,314 lost. The only way I can think this would occur is if the market suddenly plunged and blew way past the $800 stop. Is this what is intended here? Based on this example it seems the investor has little control over risk, and that de facto actual risk may vary wildly from intended risk.

2) It appears that expectancy is to a large part based on the risk the investor decides upon. In the example at the bottom of page 18 the expectancy conclusion based on an average risk of $890 is $1.096 ($975.10/890), meaning "we can expect to make a little over a dollar per dollar risked". If the investor had decided to take on an average risk of only $100, then it would be expected that $9.75 would be made for every dollar risked ($975.10/100), or if the average risk were to be $2,000 then expectancy declines to forty nine cents ($975.10/2,000). This would imply that one could make lots more profit simply by taking on less risk. I know this doesn't make any sense, but it does seem to be an implication of this version of expectancy. Am I looking at this incorrectly, or what?

3) I personally do not think too much in terms of this version of expectancy based on risk amount. Instead I think more in terms of expectancy based on investment amount. When I look at the system I have developed that uses position sizing I am interested in how much I expect to see my initial investment increase over a period of time. This seems more real to me. It is kind of interesting to view expectancy in relation to amount risked rather than amount invested, but it seems more of an academic perspective to me.

Thanks, John

A:  First, it is fairly common to see losses bigger than 1R. These occur because of tight stops, large market gaps, or psychological problems. However, they are not unusual at all. And most of the tables in the book are just examples of what could happen.

Second, risk and expectancy are not directly related. I’ve written about this extensively in Trade Your Way to Financial Freedom. Say you have a stop of $1 on a $50 stock. If the stock moves 20% and makes $10, you have a 10R gain. You could have four 1R losses and finally a 10R gain and still make 6R.

You could be right 20% of the time and still make good money. However, if your stop were $5, then you’d only make 2R with a 20% move. You might be right 50% of the time, but you might not make as much. However, the stop should be based upon the logic of your system and perhaps a study of the maximum adverse excursion against you in terms of R. 

However, you cannot look at a set of example wins and losses and change the stop and determine a new expectancy (as you are doing) without knowing the maximum adverse excursion. Your maximum adverse excursion on any given winning trade could have been 0.9R. If that were the case, then moving your stop way up means that you turned your winning trade into a losing trade.

One of the key traits of good traders is that they think in terms of risk/ reward all the time. Before they enter a trade they know their risk (as defined by a stop) and they have some idea of the potential reward. If that reward to risk is not at least 2:1, then the trade is not worth taking, and most traders want at least 3 to 1.

If you fall into the trap of thinking your whole investment is at risk, then it basically is and you play the games that most naïve investors play who think the game is picking the right stock and buying and holding it forever. I frequently give the example of the first stock that I bought at the age of 16. It went from $8/share to $20/share…. So I thought I pick the right stock. And then it went to zero and I lost it all. If I’d simply used a 25% trailing stop (i.e., $2 from the entry), I would have gotten out at $15 and made 3.5R on the investment. Perhaps I can put it this way… for every stock that goes from $10 to a $1,000 or more over time, there are probably 1,000 that eventually go to zero.

Short term traders who knew how to trade volatility made a fortune in the last quarter of 2008, while the buy and hold traders were devastated and may take years to get back to break even.—Van

 

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