Financial WMDs

Join CIO Chris Perras for the 4/24/2020 edition of Stock Talk!

Chris Perras: Good morning. I’m Chris Perras, chief investment officer at Oak Harvest Financial Group in Houston, Texas. You’re welcome to our weekly Stock Talk podcast: Keeping You Connected to Your Money. With S&P 500 sitting at about 2,800, which is basically flat for the last two weeks, even though there’s daily financial press sounding fury on every bit of news and opinion on the virus, I’m going to follow up last week’s educational piece that was on real estate investment trusts with a second educational piece.

Listeners, I apologize in advance to those who have heard me steadfastly talk on this subject, but I’m going to get up on my soapbox, and part of this podcast is going to sound like a rant. Well, sometimes, one must rant to be heard. Today’s subject matter is a financial product in the market that has been there for years. Why these things exist outside of brokered selling and pure speculation is beyond my comprehension. What are these supposed tools I’m alluding to? They are leveraged ETFs and ETNs, which are Exchange Traded Funds and Exchange Traded Notes and commodity ETFs that don’t actually own the underlying commodity. This podcast is a lesson in these WMDs, Weapons of Mass Destruction, for retail investors who do anything more than speculate short-term in them. Remember those two terms, speculation, and short term.

My first experience in these contrived in a needed financial products was my purchase of the no longer existence VXX volatility ETF, which was about nine years ago. I was sure that volatility in the overall market was set to rise over the next three or four months. I bought this WMD ETF, that being the VXX volatility index. I did this without reading the perspectives on the ETF however. It was generally thought that this ETF was supposed to be a way to invest if you wanted to hedge or bet on higher or lower market volatility.

In this case, by buying the ETF, I was investing as if there was going to be higher market volatility.

Well, over the next three months, volatility did rise by over 50%. One would think I would have made a lot of money, maybe as much as 50%. Well listeners, you would be dead wrong. “Well, Chris, you might’ve made some money right? Less than 50% because of the costs and everything else, right?” No wrong, again. I actually lost money during the time I held it, even though directionally, I was spot on, on my outlook. I took the loss and I chalked it up to being inexperienced in bad execution on my own part.

Fast forward to a few years later, apparently I didn’t learn my lesson in this event because two years later, I had the same outlook for a rise in volatility in the market, and two years later I bought the same VXX ETF as a way to profit from a rise in volatility. Two years later, volatility rose again, 50% in the ensuing months and I once again lost money. Having twice been right directionally on the market and twice lost money buying the CTF, I went to the STCs website, downloaded the VXX prospectus, which anyone can do for free, printed it out and spent the better part of a weekend reading the 110 plus page document.

Besides learning how boring my weekends were, what did I learn? I learned how this and many other financial product ETFs are structured. This ETF and many others out there, such as the USO, which has been recently the rage of all news stories, they are guaranteed to lose investors who hold them over an extended time period of months and quarters, money. They are not for buy and hold investors. They are only for very, very, very, very, very short-term traders and speculators. ETF instruments like the VXX and USO and others don’t actually own stocks or the underlying financial instrument you think they do. They own other financial products.

They specifically own a series of monthly futures contracts on the underlying commodity. That commodity might be volatility futures, or in the case of the USO ETF, it’s oil futures. The way that these ETFs work is that every month, at or before the futures contract expires, they have to sell the current month’s futures because they can’t and will not take delivery of the underlying commodity. Now they go and they take the money from their sales, and then they buy the next month’s or a few months’ forwards futures contract.

Over time because of the way most financial future markets and their forward price curves are structured with a lower price now and a higher price in the future due to things like storage costs and financing costs, a buy-and-hold investor in these products is almost guaranteed to lose money. This upward-sloping pricing curve is called contango, and this pricing dynamic means a buy and hold investor fights monthly price decay when the markets are normally priced. This structure and the inability of financial speculators to actually take delivery of a commodity product is why we saw domestic oil prices for WTI crude oil trade below zero, and actually down to negative $37 a barrel earlier this week.

Each futures contract held by a financial speculator or a commodity ETF that is trading oil was responsible for taking actual delivery of a thousand barrels of oil per contract when the futures contract expired. Unfortunately, due to the virus and its demand destruction on energy uses and products, the storage space for the liquid energy products is near capacity, and there are few, if any places to store physical oil. If you are a speculator in these markets, or you’re firm behind the USO ETF, what are you going and to do as you approach the futures contract expiration, you will sell it at almost any price.

That includes a negative price because you have no way to take physical delivery of it, and you have no place to store it. To put this in perspective, if you had a very large backyard pool, one that say held 45,000 gallons, you could drain it fully and fit only one oil futures contract about 42,000 gallons into your pool. Besides these poorly structured ETFs, there exists another product offering called the ETN, which stands for Exchange Traded Note. These two are things that we as a team at Oak harvest do not believe in.

They are structured financial products with very high fees, both stated and hidden. These products are usually not actually what they appear either. This is a 20 to $25 billion market dominated by one money manager. When you purchase an ETN, you do not own the underlying financial instruments. Let me repeat that. You do not own stocks and bonds. ETNs are credit instruments issued by banks that can enable an investor to make leveraged bets on investments. These include stocks, bonds, and commodities, but once again, you do not own those stocks, bonds, and commodities. You own a credit instrument.

That credit instrument is backed by a bank. It is backed by the issuer, not the registered investment advisor. Take for example, the FLG ETN, that is a large holding in most of the portfolios of the largest registered investment advisor in the United States. You’ve probably heard or seen as commercials, bashing mutual funds, annuities and insurance products. He’s quite vocal in stating how these products have high hidden fees, and he would never use them in his portfolios. The name of this product in his portfolio is “enhanced.” What that really means is it’s leveraged. Why do they call this enhanced? It’s pure marketing.

Most investors know the risk of, but enhanced who doesn’t like something enhanced. It sounds like a new and improved dishwasher detergent. It’s got to be better if it’s enhanced. In reality, this enhanced is just old school financial leveraged at a very high cost. This ETN actually borrows money to mimic two times the moves in its underlying index. On the way up, it goes up about two times as fast, but probably a bit less because of the high fees in the ETN. On the way down, it goes down slightly more than two times as fast due to the fees and illiquidity of the product.

Leverage works both ways. However, due to the product structuring of both owning derivatives and also borrowing money to leverage results, the all-in annual cost of these exchange-traded notes can total three to 4% per year. While the investment advisor is not retaining these fees, the investor is certainly paying for them out of his performance. I want to provide a brief list of some of the larger ETFs that are either leveraged, trade futures, or ones that don’t actually own the underlying commodity you’d expect them to. This is definitely not a comprehensive list, you can go Google that and find a little list. There are hundreds of these things out there on the volatility side. Now that the VXX doesn’t exist, that T VIX and the UVXY are the ones to stay away from on the commodity side, stay away from the USO and something called gush, G-U-S-H on the stock side, beware of the F-L- G-E the F-I-H-D the F-R-L-G, the F-B-G-X, the S-P-X-L, and the S-P-X-S, [music], the lessons for listeners here is you must look behind the scenes to see what you really own preferably before you invest in it. It doesn’t matter if it’s a mutual fund and ETF or your registered investment advisor. You must do some research to see if the financial instrument or your advisor is actually as advertised at Oak harvest. We are comprehensive long-term financial planners. What this means that as our client, you and your financial advisor should have a financial plan that is independent of volatility in the stock markets. If you are retired or in the process of retiring, give us a call at (281) 822-1350. We are here to help you plan your financial future and help smooth the financial path you have into, and through your retirement years with a customized retirement planning, many blessings stay safe. This is Chris Perras at Oak harvest financial group.

Speaker 2: The proceeding content expresses the views of the speaker and is for informational purposes. Only it is based on information believed to be reliable when created, but any cited data, statistics, and sources are not guaranteed content ideas and strategies discussed may not be right for your personal situation and should not be considered as personalized investment tax or legal advice or an offer or solicitation to buy or sell securities. Investing involves the risk of loss and past performance does not guarantee future results.