ETFs With Credit Risk

Investors should beware of the increasing number of ETFs that use derivative contracts to achieve investment objectives. While the use of swaps has helped many ETF issuers provide investors with exposure to previously inaccessible regions of the market, these ETFs layer another dimension of risk onto already-concentrated investment objectives.

Before investing in ETFs like U.S. Natural Gas(UNG Quote) or Direxion Daily Financial Bear 3X(FAZ Quote), investors must understand the counterparty risk involved in achieving these fund objectives.

Traditional ETFs track an underlying index and are representative of a basket of stocks. The iShares Dow Jones U.S. Financial Sector Index Fund(IYF Quote)(IYF Quote), for example, tracks the Dow Jones U.S. Financials Index, essentially a basket of the stocks like JPMorgan Chase(JPM Quote) and Bank of America(BAC Quote). Investors can simply visit the fund's website to see how many shares of each financial firm are represented in the overall ETF.

Ultra and leveraged ETFs use traditional indices plus swaps to achieve an investment objective. The ProShares UltraShort Financials ETF(SKF Quote) also uses the Dow Jones U.S. Financials Index. Instead of tracking a basket of stocks, SKF tracks a combination of financial instruments such as futures and swaps.

The prospectus for SKF describes swaps as complex instruments with counterparty risk:

"Swap agreements are two-party contracts entered into primarily with institutional investors for a specified period ranging from a day to more than one year. In a standard "swap" transaction, two parties agree to exchange the returns.... The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease."

Complex financial derivatives, like swaps, have been the target of scrutiny in the past. Credit default swaps have been at the heart of many of the problems in the banking sector. While swaps are useful to execute certain transactions, their counterparty risk and regulatory standards can make them hazardous to unwitting investors.

Managers of the UNG recently announced that they would decline to issue newly-approved shares of the fund and seek out alternative investment strategies such as swaps. This decision comes in the wake of a series of hearings by the Commodities Futures Trading Commission (CFTC).