beware etfs

[Skydaemon]

I just had an "oh crap" moment while thinking about the financial meltdown in progress.

sample proshares etf holdings

Read the above, pay particular attention to phrases like these:

1 = ProShares may invest in equity securities and/or financial instruments (including derivatives) that in combination, should have similar daily price return characteristics to the fund's benchmark.

3 = Derivative contracts are priced to reflect the underlying index yield and will not generate dividend income. Because ProShares invest in derivatives, they will not have dividend distributions that reflect those of their applicable indexes.


Now not every etf is like this, but I think more than half are.

You know how all these etfs suddenly appeared out of nowhere the last couple of years? Financial magic right? Every tried to find out what they are holding for underlying assets beyond "something which is approximately tracking some sector/currency/index/whatever and possibly leveraged".

Well what they are is a combination of derivative swaps in a lot of cases.

Recall the derivative swaps are those insurance contracts for various events of all kinds (currency, index movements, credit defaults you name it it's everything).

So basically, each of these things conceptually needs a counterparty capable of paying them out in order to have any value.

I'd bet those counterparties are probably big banks, maybe even bear stearns.

So in other words, if these counterparties collapse, insurance they backstop becomes worthless.

That's all a derivatives swap is, so I'm speculating that in that event the derivative swaps become worthless.

If that is true, then any etf based on derivative swaps (probably most of them) will also be worthless.

I'd suggest either getting out of heavy weightings in etfs, or at least evaluating where they get their value from so you know what you're risking by buying them.

I always wondered who the poor suckers were who owned all these worthless trillions in derivative swaps, and this afternoon I realized it was people like me.

Please fill me in if you have any insight one way or the other.