This March, as the market stumbled over the Bear Stearns (BSC) collapse, ProShare Advisors posted a small notice on its Web site: "Bear Stearns is not a counterparty to any of the financial instruments held by ProShares." That's about the only information customers of the Bethesda (Md.) manager's most popular exchange-traded funds can get about what investment banks ProShares does business with, however. And it's these banks, or counterparties, that most "bear" funds rely on to take the other side of the complex financial deals that underlie their performance.
After the string of nasty surprises in the markets, investors want to be reassured that a company on the other side of a deal will be around to hold up its end. But with some of these bear, or "inverse" funds, determining who those counterparties are is a big challenge.
Take ProShares, which, with parent company ProFunds, manages several inverse exchange-traded funds (ETFs) and mutual funds, which rise when markets fall. Assets in its short ETFs have rocketed from zero to $12 billion in under two years, and these ETFs are the most popular in terms of new sales this year.
To understand the possible consequences of a counterparty going bankrupt, consider how an inverse fund works. ProShares uses derivative contracts called swaps to get the inverse return of indexes such as the Standard & Poor's (MHP) 500-stock index. (A swap promises an exchange of returns between two financial institutions.) To bet against the Nasdaq 100 Index, for instance, a fund would enter into a swap agreement with a counterparty that agrees to pay it 1% for every 1% the Nasdaq falls. On the flip side, the money manager would pay 1% for every 1% rise.
ProShares, Rydex Investments (RYNVX), and Direxion Funds, the three major bear fund players, use swaps extensively. The primary counterparties for all of the market's swap transactions have been hedge funds and investment banks. Since bear funds are designed to protect portfolios during a meltdown, the prospect of a troubled counterparty is potentially problematic.
With ProShares, it's impossible to determine a counterparty's credit quality and the damage that might stem from a bankruptcy since it won't disclose counterparties, and swaps are privately negotiated. "There are confidentiality agreements between us and our counterparties," says Michael Sapir, CEO of ProShares and ProFunds. "That's part of our business model."
Such secrecy is unusual in the fund world. Many bond mutual funds invest in credit swaps and disclose counterparties. Direxion uses Goldman Sachs (GS) as its primary counterparty. "I'm a little surprised other firms aren't disclosing counterparties," says Daniel O'Neill, Direxion's president. "This is the kind of info investors want to know in a turbulent market."
Rydex, ProShares' main competitor, doesn't disclose counterparties, either. Senior portfolio manager Ryan Harder is more forthcoming about details of his swaps. "For each ETF, we have a rule that we have three swap counterparties in place to diversify any exposure," he says. All counterparties must be A-rated in terms of credit quality, and if their ratings fall, Harder stops doing business with them. ProShares' Sapir says only that it has adequate safeguards in place.
It's not clear whether a bankrupt counterparty would mean more than a small monetary loss and a big loss in peace of mind. For example, Rydex' swaps typically cover a three-month period, and until a contract expires, gains or losses for either side of the deal are bookkeeping entries—no cash is exchanged. That means the maximum potential loss Rydex could have from a bankrupt counterparty would be three months' worth of gains that the counterparty couldn't pay on an expired contract. Rydex's Harder says in practice this wouldn't happen because the relationships it has with counterparties let it close out a swap position on any day. O'Neill says that holds for Direxion, too.
"A PRECARIOUS STATE"
Should managers have to deal with a bankrupt counterparty, they may have difficulty collecting what they're owed. Rydex and Direxion's counterparties require them to post cash collateral in a segregated account to cover losses they might have on their side of swap deals. But their counterparties don't do the same. "The investment banks are the provider of the swap contract, and they're bigger firms than us, so they have the stronger bargaining position," says O'Neill. Notes Roger P. Joseph, a securities lawyer at Bingham McCutchen in Boston: "If you don't have collateral...you have to line up with the other unsecured creditors."
There are a few alternatives to such funds for defensive investors. Both the Prudent Bear Fund (BEARX) and the Grizzly Short Fund (GRZZX) use individual short positions instead of swaps. "I wouldn't want to have any investment bank as my counterparty right now," says Prudent Bear manager David Tice. "The entire investment banking industry is in a precarious state." Even if you're sanguine about the fate of the investment banks, when buying a product designed to hedge your bets, it's nice to know who's on the other side of the deal.