I explained how exchange traded funds (ETFs) work on Wednesday. Despite their reputation as a ‘simple’ way to invest, there’s more to them than most people consider. If you haven’t read that analysis, you can review it here.
As a refresher, Van Eck’s popular Junior Gold Miners ETF [NYSE:GDXJ] has hit a few problems. It’s experienced capacity issues, with GDXJ becoming too popular. And it could also experience some form of liquidity crisis in the future. That presents a massive potential problem.
Remember, you aren’t the legal owner of your ETF units. Most ETFs — especially international — aren’t CHESS sponsored. The units aren’t recorded in your name. That compares to domestic CHESS-sponsored shares, which are held in your name.
CHESS-sponsored shares make you the legal owner of each company. If your broker collapses, your domestic (ASX traded) shares can be transferred to another broker.
ETFs, however, are questionable. What happens to your shares if the ‘legal owner’ (custodian) or investment manager (i.e. Van Eck) goes under during a liquidity crisis?
Trade with your eyes wide open
I emailed Van Eck about my concern in September last year. Henry Mortlock, Business Development Manager, responded:
‘Van Eck are not beneficial owners of the assets, nor is the custodian. In the event of bankruptcy our creditors would have no recourse to these assets. We would be removed as the manager but the [management investment scheme] MIS and its assets would continue to be beneficially owned by the unit holders. They could then vote to either appoint a new manager or liquidate the assets (all of which are listed shares).
‘Within the custody house it is a legal requirement that the shares be held in segregated accounts to ensure that the rights of the beneficial owners can be easily traced. Even if the custodian went under the liquidators would not be entitled to the assets. They would be required to transfer them to the new custodian that we would appoint.’
Van Eck is the ‘fund manager’ for GDXJ. It manages the buying and selling for the ETF. The acquired shares are held in segregated accounts with a third-party custodian, such as State Street, JPMorgan, BONY, etc. Being the custodian, technically, these firms are the ‘legal owners’ of your ETF shares.
Treat third-party segregated accounts with extreme caution. The custodian could collapse, no matter its size.
Lehman Brothers — once the world’s third largest investment bank — and Bear Stearns went under during the early days of the GFC in 2008. State Street, JPMorgan or BONY could all go under during the coming sovereign debt crisis.
What would happen to your GDXJ — or any ETF — units in that scenario? Remember, you don’t legally own the shares held within the ETF.
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Henry Mortlock says, ‘…the shares [would] be held in segregated accounts to ensure that the rights of the beneficial owners can be easily traced.’
OK. Fair enough. But during a global liquidity event, would that really be the case?
MF Global was a major derivatives broker in 2011. It provided exchange-traded derivatives, such as futures, options and ETFs. On 31 October, 2011, MF Global executives admitted to a transfer of US$700 million from customer accounts to the broker-dealer. It also look out a loan of US$175 million in customer funds. That was used to help MF Global’s UK subsidiary cover (or mask) liquidity shortfalls on 28 October, 2011.
Shareholders and account holders lost everything. It was one of the greatest frauds since Enron. During times of chaos, MF Global directors saw a massive pile of cash for the taking. They thought they could use it to save the business. If they were successful, it would have been a miracle and the cash would have been returned.
That didn’t happen.
MF Global directors were trading with client money held in ‘third-party segregated accounts’.
This highlights how you can never truly know what will happen during times of crisis. For that reason, I recommend that you be relatively cautious when it comes to ETFs.
Tread carefully with ETFs
Of course, that doesn’t mean you shouldn’t buy ETFs. Just invest with your eyes wide open.
You can also protect yourself from a liquidity crisis…
ETFs have a bid (buy) and ask (sell) price. The difference between both prices is the spread. During US trading hours, when GDXJ is available for trading, the spread is typically a few cents. It’s about 10 cents as we speak.
Watch out for when the spread starts blowing out during volatile times. That’s when you should start to worry. When that happens, market makers widen the spread, knowing something’s wrong. That’s the time to get out — before everyone else rushes for the exit gates all at once.
Market makers widen the spreads for that reason. That could make GDXJ — and other ETFs — less appealing, and lead to a liquidity event.
Liquidity is a serious potential issue for the future. The current issue for Van Eck, however, stems from capacity — holding more than 20% of each stock. The Australian reported:
‘Van Eck’s solution, announced in April, was to rewrite the rules that decided which miners could be included in the $US3.7 billion ($4.9bn) index. Previously, miners would be excluded if their market capitalisation went above $US1.6bn. Instead, that upper limit was increased to $US2.9bn.
‘According to one fund manager, the market moves in anticipation of the Van Eck rebalance have cost the fund more than $US300 million in value as it buys and sells shares in miners that have already had their prices inflated or deflated by investors anticipating the fund’s moves.’
It’s been an absolute disaster. In the lead-up to these index changes, many investors do the maths, and figure out which companies will stay and go from the ETF. Deletions get sold off in advance. In that case, GDXJ eventually sells the shares at depressed prices and buys at elevated prices.
If you’re interested in buying GDXJ, just be careful. It’s called the Junior Gold Miners ETF. But because of popularity, the size of the companies held in the index is growing. That means you may not be buying a true portfolio of junior gold companies. When the gold bull market takes off, the size of companies included in the index will only grow.
In my premium service, Gold Stock Trader, I’m recommending the smallest and most undervalued gold juniors. I’m tipping stocks that could go up 10 to 100 times during the next gold bull market. At the moment, you can still buy these companies for cents on the dollar because no one cares about them.
That will change when the bull market starts. And don’t be surprised if the stocks significantly outperform those included in GDXJ.
And you will legally own the stocks, as you can own them CHESS sponsored. Most of the ‘penny gold’ stocks are listed on the ASX. You can decide how much of each you want to own. And in the event of a liquidity crisis, the shares will be in your name — not a custodian’s.
The bottom line: Cut out the middleman and build your own junior gold ETF. For more details, click here.
Editor, Markets & Money