Ultra ETFs and Counterparty Risk

In a few previous posts, I mentioned using leveraged ETFs as an investment tool. If you own any shares of ProShares, ProFunds or Rydex leveraged funds, keep reading. The rest of you are free to go recess early today.

This weekend I read the prospectus for all three companies providing leveraged ETFs. A leveraged ETF is a stock ticker that matches some index in a leveraged relationship. For example, I own the ticker SKF, which is double the inverse of the Dow Jones Financial Index. As financial companies decline in value, my ETF goes up in value at double the rate. In addition to the normal risks associated with investing, these shares also have something called counterparty risk. In order to achieve this leverage the companies engage in derivative trading. As long as the parties engaged in the trading are financially healthy, there is no counterparty risk.

From the ProShares prospectus:

If a counterparty becomes bankrupt or otherwise fails to perform its obligations due to financial difficulties, the value of your investment in a Fund may decline. A Fund may experience significant delays in obtaining any recovery in a bankruptcy or other reorganization proceeding and a Fund may obtain only limited recovery or may obtain no recovery in such circumstances. The Funds typically enter into transactions with counterparties whose credit rating is investment grade, as determined by a nationally recognized statistical rating organization, or, if unrated, judged by Proshare Advisors to be of comparable quality.

There is a sentence up there that makes me nervous.

The Funds typically enter into transactions with counterparties whose credit rating is investment grade, as determined by a nationally recognized statistical rating organization…

Any reader of Calculated Risk or Mish’s Global Economic Trend Analysis is already aware of the hijinks being played by the ratings agencies. Credit ratings are becoming increasing less trusted. It is possible that the unnamed counterparties behind the leveraged ETFs have toxic balance sheets and the ratings agencies are looking the other way, hoping the problem resolves itself.

How does one measure this risk? I haven’t figured out a way. My research tells me the chances are very remote. However, having read When Genius Failed, which was an accounting of the 1998 LTCM crisis and watching the Bear Stearns disaster unfold, tells me the risk does exist. And if it happens, there will be no time to get out.

There is a way to play the Ultra ETFs that avoids counterparty risks. It involves either buying options or shorting the opposite ETF (ex: short the Ultra Long if you are bearish, short the Ultra Short if you are bullish). However this is usually not permitted in IRA accounts.

My strategy for next week is to start exiting my ProShares ETFs and move investment money to managed bear funds that aren’t exposed to counterparty risk. Prudent Bear (BEARX) and Grizzly Short (GRZZX) are two that I’ve discovered. Prudent seems to do better in a bull market and Grizzly does better in a bear market.