More Reverse Splits, or Just Closure, Possible or Needed in ETFs (FAS, FAZ, UYG, BAC, BHH, ARBA, IIH, AKAM, VRSN, UNG, USO, GLD, SDS, SPY, NYX, NDAQ)

We have been large fans of exchange-traded funds, exchange-traded notes, and other exchange-traded instruments which are open for trade throughout the day that are allowed to be invested in just like a stock.  But with all new and growing markets, there are risks that need to be kept in check.  There are some leveraged ETF’s and their inverse counterparts which might need to see reverse share splits in the near future.  The notion of so many low-priced shares being so active may wreak havoc as the funds managing each ETF try to keep up with appropriate derivatives and in buying and selling shares of the components that are supposed to be the underlying securities.  There are even a few ETF’s which should probably just be closed down entirely and liquidated to holders.  Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and The Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) are both prime examples of ETFs which skew total daily exchange trading volume numbers because of low share prices today and massive trading volume.  This is not meant to pick on the fund groups because they created trading vehicles which they did not expect to see some of these moves.  There are many more ETFs and ETNs to consider here.

Direxion just announced a reverse split for another ETF yesterday, but not its two financial triple-leverage ETFs.  Direxion Daily Financial Bull 3X Shares (NYSE: FAS) is now back down close to $8.00 per share, yet it trades 250 million shares on an average day.  The Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) is barely above $5.00 and trades more than 200 million shares on an average day.  So between the FAS and FAZ, you have an average of more than 450 million shares, and at today’s prices that is close to $3 billion worth of nominal value.

This review discusses a portion of the ETFs and ETNs and the ones under discussion today, along with underlying key companies, are Ultra Financials ProShares (NYSE: UYG), Bank of America Corporation (NYSE: BAC), B2B Internet HOLDRs (AMEX: BHH), Ariba, Inc. (NASDAQ: ARBA), Internet Capital Group (NASDAQ: ICGE), Internet Infrastructure HOLDRs (AMEX: IIH), VeriSign Inc. (NASDAQ: VRSN), Akamai Technologies Inc. (NASDAQ: AKAM), United States Natural Gas (NYSE: UNG), United States Oil (NYSE: USO), SPDR Gold Shares (NYSE: GLD), UltraShort S&P500 ProShares (NYSE: SDS), SPDRs (NYSE: SPY), New York Stock Exchange (NYSE: NYX) and the NASDAQ OMX Group Inc. (NASDAQ: NDAQ).

Ultra ETFs…

Ultra Financials ProShares (NYSE: UYG) is another low-priced active ETF.  Its seeks twice the daily performance of the Dow Jones U.S. Financials index, and normally invests 80% of the fund’s assets in financial instruments with economic characteristics that should be twice the return of the index.  With a trading range of $1.37 to $25.03 over the last year, it is easy to see where the volatility can go.  This trades nearly 100 million shares on average, yet its price is $3.65 after a 2.5% gain.

Merrill Lynch HOLDRs

Now that Bank of America Corporation (NYSE: BAC) owns Merrill Lynch, it is time for it to clean house on at least two of the HOLDRs family of ETFs.  HOLDRs are hybrd ETFs that gave investors a chance to individually own shares directly in underlying stocks. Based on how much direct mail was sent out just a year or two ago on the Semiconductor HOLDRs, B of A could save everyone some serious money by not having to send out that proxy and annual report material to holders of each stock. Let alone a headache.

The B2B Internet HOLDRs (AMEX: BHH) is an old legacy ETF that should just go away.  While it trades over 30,000 shares on average, it is deep into penny-stock territory.  Now that its last major constituent was acquired, Ariba, Inc. (NASDAQ: ARBA) and Internet Capital Group (NASDAQ: ICGE) are the only two holdings left.  Maybe this is just for pairs trading on days when Ariba has big news.

Internet Infrastructure HOLDRs (AMEX: IIH) is another one of the old legacy ETFs from the Internet Bubble days that went from active and high priced to micro-cap and generally thin volume.  Of course the 266,000 shares around noon is a slap in the face against the argument today, but this frequently sees less than 10,000 shares.  The page for the weighting also has over 82% of the entire ETF weighting as being only two stocks: VeriSign Inc. (NASDAQ: VRSN) with 55.76% and Akamai Technologies Inc. (NASDAQ: AKAM) having 27.9%.

ETFs and ETNs in Commodities….

There are two funds which track energy commodity prices, and these ETFs have actually been accused of manipulating the price of underlying commodities.  Jim Cramer recently blasted the United States Natural Gas (NYSE: UNG) fund.  He said this one has actually become large enough because it gave traders a chance to buy big enough quantity of natural gas that he thinks the fun ran up prices because it invests almost entirely in near-month natural gas futures contracts.  If that gets $100 million in buy orders for the ETF, that goes directly into the natural gas futures market.

A similar situation was noted earlier this year and last year during the oil boom and bust: the United States Oil (NYSE: USO) ETF is meant to track the spot price of West Texas Intermediate light sweet crude oil.  Yet during the boom and bust of oil, futures traders were able to game the “USO” because of its order flows and high demand followed by an exodus.  Whether or not this one is responsible for running up or running down the commodity is something that will never be proven.  How many speculators told Congress that speculators were not responsible for the run-up in crude last year?  Sometimes the answers are obvious, but are not easy to quantify.

And the beloved gold ETF the SPDR Gold Shares (NYSE: GLD) has good intentions too.  But it goes out and purchases direct bullion and exchange baskets.  This ETF is so large that it is still said to be among the top 10 holders in entire gold reserves.

In commodities, it would seem that FINRA might consider making some of these trade as closed-end funds with limits to size in relation to the entire market of the underlying commodity.  That is not likely to occur, but it is a thought.  If inflation ever gets too heated, don’t be too shocked if and when you see a sudden Congressional press or or a FINRA-led press to stop inflows from making the commodity prices move solely be ETF owners buying more and more.

Two S&P ETFs That Do Work…

The UltraShort S&P500 ProShares (NYSE: SDS) against the SPDRs (NYSE: SPY) is an example of a pair of an inverse ETF and corresponding long ETF that actually work the way these were meant to work.  The SDS trades 45 million shares on average and that is over $2 billion worth of nominal value.  It is technically twice the inverse performance of the S&P 500 Index.  The “Spies” trade about 275 million shares a day, yet the price is nearly $90.00 (one-tenth of S&P).  That is over $24 billion worth of stock in nominal value.  Compare this dollar volume daily to that of the FAS and FAZ.

Other Issues to Consider

There is another notion here to consider, and that is the New York Stock Exchange (NYSE: NYX) and the NASDAQ OMX Group Inc. (NASDAQ: NDAQ).  Both major exchanges have relaxed the old absolute guidelines on the $1.00 rule.  There are many stocks that fell under $1.00 that are just too active in trading volume.  Booting those funds off the exchange because of the numbers of stocks they own and because of the number of shares would be the exchanges intentionally cutting off some of their own trading volume business.  How many operating businesses want to intentionally choke their own business and income streams?  Yep, not many.

It is impossible to say whether or not a reverse split would make a huge difference in the volatility of low-priced ETFs.  You could even make a case that if the prices were adjusted higher via a reverse stock split that the underlying ETFs would see more volatile price moves as each penny is worth less and less on a percentage basis.  For a $5.00 stock, each penny up or down is 0.20% and that is before any commissions are applied.

There are other risks here if ETFs are allowed to grow indefinitely.  Imagine if the entire world decided to trade ETFs rather than ever invest in individual stocks.  This would make the money flows of an ETF determine the direction of a stock.  Imagine if a company was small and attractive, but was not part of any ETF.  That company would be public, yet effectively shut out of the market.

This list of questionable ETF and ETN investment is actually far longer than just these mentioned today.  We will be following up with each of these individually over the next week or two by fund family and/or by asset class.  You can also learn more about these via subscribing to our open email distribution list.

Jon C. Ogg
June 23, 2009