Futures-Based Commodities ETFs
By: Ilan Guedj, Guohua Li, and Craig McCann (Jan 2011)
Published in The Journal of Index Investing, Summer 2011, Vol. 2, No. 1: pp. 14-24.
Commodities Exchange Traded Funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging.
This paper examines the sources of the deviation between futures-based commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs.
Leveraged ETFs, Holding Periods and Investment Shortfalls
By: Ilan Guedj, Guohua Li, and Craig McCann (Aug 2010)
Published in the Journal of Index Investing, Winter 2010, Vol. 1, No. 3: pp. 45-57.
Leveraged and Inverse Leveraged ETFs replicate the leveraged or the inverse of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.
The Anatomy of Principal Protected Absolute Return Notes
By: Geng Deng, Ilan Guedj, Joshua Mallett, and Craig McCann (Jul 2010)
Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011.
Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies.