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Macro trading, liquidity and ETFs

ithout doubt, exchange traded funds (ETFs) 1 have m a d e tra d i n g a ro u n d macroeconomic events easier. The proliferation of ETFs has ensured that complex investment strategies are now available to both retail and institutional investors. Investors do not require the resources of George Soros or Jim Rogers to trade based on significant global occurrences. Take the example of cotton. For the past few years, agricultural commodities have been a favourite asset class for many within the investment community. Cotton was no exception. Cotton traded at US45 per pound in January 2009. The commodity then started the year 2010 at 72/lb,2, reflecting an increase of 59% over one year. Clearly, action in the cotton market began even before severe floods hit Pakistan in late July 2010. Historically, Pakistan ranks fourth in global cotton production.3 Pakistan is to the cotton market what Iran or the United Arab

Investors and traders must keep in mind several basic principles

By Imran Ahmed futures contracts, a common occurrence in markets with rising prices. Moreover, an ETF like BAL poses potential liquidity challenges which generally do not exist for futures traders. During the past three months, BAL had an average daily trading value of almost US$6.1 million relative to BALs net assets of $72.2 million. 4 Surely, ETFs have specific share creation and redemption rules which may help bypass reported daily trading values, especially in extraordinary situations. However, an ETFs assets under management (AUM) remain a good indicator of the ease of establishing large positions in a particular ETF. On the surface at least, BALs fund size appears insufficient for larger institutional investors to quickly open meaningful long or short positions. The cotton example reasonably illustrates the situation across a whole host of specialised ETFs, including iPath DJ-UBS Coffee TR Sub-Idx ETN (JO), Global X Uranium ETF (URA) and Teucrium Corn Fund (CORN). Still, there are many examples where ETFs provide a good trading vehicle for macro traders. Gold is just one such example. The SPDR Gold Shares ETF (GLD) tracks the spot price of the yellow metal tightly enough for a trader or investor to use GLD as a proxy for the real asset. That

However, with the establishment of the iPath DJ-UBS Cotton TR Sub-Idx ETN (BAL) in June 2008, retail investors could track cotton price movements through BAL. Unfortunately, like many ETFs, BALs performance reflects the vagaries of using futures contracts to track a commoditys price. Consequently, there are deviations between BALs price performance and the spot price of cotton. To be sure, BAL tracked the spot price of cotton well during 2010. However, an investor requires better tracking of spot prices than BALs performance over the past few years. ETFs which rely upon futures contracts or other synthetic means to generate returns for a given asset class are often unable to closely replicate the performance of spot prices. The difference in performance is typically a result of the need to replace monthly futures contracts as they expire. A phenomenon known as contango occurs when old futures contracts are replaced with more expensive new

ETFs which rely upon futures contracts or other synthetic means to generate returns for a given asset class are often unable to closely replicate the performance of spot prices
Emirates is to the oil market. Thus, when one fifth of Pakistans land area, including prime cotton growing regions, was underwater it was rational to expect cotton prices to continue their upward trend due to a reduction in future supply. It is likely a macro trader may have reacted to news of flooding in Pakistan by opening a long cotton position. Until the advent of ETFs, investors would typically create a long cotton position by purchasing cotton futures. Nonetheless, futures contracts tend to be overly risky for retail investors. Inherent in any futures contract is a large amount of leverage thereby allowing a small amount of capital to control a large investment. 6
ETFI ASIA 2011 Q4

Table One
Price change from previous 12 months (%)
Cotton (spot) January 4, 2010 August 2, 2010 January 3, 2011 October 3, 2011 58.9% 48.0% 88.5% -0.1% BAL 30.8% 20.8% 90.7% 28.3% Deviation (ETF - Spot) -28.1% -27.2% 2.2% 28.5%

Source: Deodar Advisors, Wall Street Journal Online, Market Data Center and Yahoo Finance. Prices retrieved on October 4, 2011

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for investors to initiate large positions in a short period of time. 4. Part of an ETFs appeal is that it can be sold short, thus allowing investors to benefit from a drop in prices. Here too, an ETFs liquidity is a crucial element. The size of an ETF will determine the ease with which ETF shares can be borrowed for a short trade. Hence, short trades, even large ones, in popular ETFs like SPY (SPDR Standard & Poors 500) or DIA (SPDR Dow Jones Industrial Average) may be routinely executed. However, borrowing to short sell shares in ETFs like BAL or VXX (iPath Standard & Poors 500 VIX Short Term Futures ETN) might prove a trying experience. ETFs have had a salutary impact on investors ability to trade on market moving economic or political events. The ease of trading an ETF through an ordinary broking account permits all classes of investors, from retail to institutional, to implement investment strategies which attempt to profit from changes in the global socio-political environment. ETFs of specific currencies, commodities, sectors and countries may be used for such trades. However, investors ought to research an ETFs structure and holdings prior to implementing such trades. Not all ETFs are created equal.
Imran Ahmed is a principal at Deodar Advisors LLP. He can be reached at Imran@deodaradvisors.com

Table Two
Price change from previous 12 months (%)
Gold (spot) January 4, 2010 August 2, 2010 January 4, 2011 October 18, 2011 31.4% 23.8% 23.6% 21.8% GLD 30.0% 23.1% 22.7% 20.5% Deviation (ETF - Spot) -1.4% -0.7% -0.9% -1.3%

Source: Deodar Advisors, Wall Street Journal Online, Market Data Center and Yahoo Finance. Prices retrieved on October 19, 2011

GLD holds physical gold in vaults for each ETF share issued undeniably has much to do with the ETFs low tracking error. The $71.8 billion ETF5 has generally kept its annual deviation from the London evening gold fix price to below 1.5% for the past few years.6 When trading on macroeconomic events using specific asset classes, there are several basic principles investors and traders alike must keep in mind. 1. Getting the investment thesis correct is not sufficient to guarantee a return equivalent to trading a particular asset on the spot or futures market. Investors who used the BAL ETF as a proxy for cotton prices know this story well. Investors must also ensure
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that the chosen ETF faithfully tracks the spot price of the target asset. 2. An ETFs structure has a direct linkage with its ability to replicate spot prices. Generally, synthetics do not track spot prices as well as ETFs which purchase physical assets of the underlying. This holds true not only for ETFs tracking commodity prices, e.g. oil, cotton, but also for ETFs tracking indices, e.g. DXD (ProShares UltraShort Dow 30) and SSO (ProShares Ultra S & P 500). 3. For large investments, liquidity considerations are an important factor in executing a successful trade, especially if the trade is short-term in nature. Many ETFs trade in underlying assets which are not liquid enough

For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). All cotton prices refer to cash spot 1 1/16 strand lw-md Mmphs, per lb-U. Prices obtained from the Wall Street Journal Online, Market Data Center accessed on October 4, 2011. http://online.wsj.com/mdc/public/page/2_3023-cashprices.html?mod=mdc_pastcalendar Source: US Department of Agriculture as quoted online by the National Cotton Council of America accessed on October 4, 2011. http://www.cotton.org/econ/cropinfo/cropdata/rankings.cfm Source: Yahoo Finance retrieved on October 5, 2011. http://sg.finance.yahoo.com/q?s=BAL Source: Yahoo Finance retrieved on October 19, 2011. http://sg.finance.yahoo.com/q/pr?s=GLD All gold prices refer to cash spot London p.m. fixing per troy ounce. Prices obtained from the Wall Street Journal Online, Market Data Center accessed on October 19, 2011. http://online.wsj.com/mdc/public/page/2_3023-cashprices-20100802.html?mod=mdc_pastcalendar

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ETFI ASIA 2011 Q4