Europe’s Financial Crisis Sends U.S. Stocks Lower

Fears over the state of European banks after the European Central Bank lent dollars to a eurozone bank sent European markets plunging and have started a huge sell-off in the U.S. One bidder borrowed $500 million from the ECB and the news suggests at least one bank is having problems getting the cash it needs, according to Financial Times and CNBC.

At Thursday’s close, the SPDR S&P 500 (SPY) tumbled 4.3% to $114.51.
The SPDR Financial Select Sector Fund (XLF) sunk 4.8% to $12.38.
The SPDR Technology Select Sector Fund (XLK) fell 4.9% to $23.08.
And finally, the SPDR Gold Trust (GLD) rose 1.9% to $177.72.

Last week regulators in Italy, Belgium, France and Spain banned short-selling of financial stocks in an effort to curb volatility and bring some order to markets. How is that working out for you? Meanwhile, it’s nearly impossible to get any numbers on the shorting of U.S. stocks or ETFs on short notice, I wouldn’t be surprised if investors were using U.S. ETFs to short the European financial stocks.

Meanwhile, here are 4 funds that measure global financial stocks.
iShares MSCI Europe Financials Sector Index Fund (EUFN), of which banks make up 52% of the portfolio, plummeted 8% to $16.68.
iShares S&P Global Financials Sector Index Fund (IXG) plunged 5.2% to $36.99.
SPDR EURO STOXX 50 (FEZ) dived 5.5% to $31.06.
iShares MSCI United Kingdom Index Fund (EWU) skidded 4.6% to $15.71.

Finally, the ProShare UltraShort MSCI EAFE Fund surged 9.7% to $28.75. With a ticker of (EFU), this is probably the most appropriate sentiment of the day.

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XLF Rallies on Bank Buying Bullishness

StreetInsider.com reports that the Financial Select Sector SPDR ETF (XLF) is surging today as investors aggressively buy bank stocks on the heels of the group’s recent bounce.

Midafternoon, the Financial Select Sector SPDR. which tracks all the financial-services companies in the S&P 500 Index, was up 1%, compared to the 0.2% rise in the S&P 500. The ETF had been up as much as 1.2%.

To highlight the level of investors interest, mid afternoon Wednesday, the trading volume in the Financial Select Sector SPDR was 45 million shares, topping the 37 million traded in the SPDR S&P 500 (SPY), normally the most activity traded ETF on the market. On an average day, the SPDR trades 179 million, twice as much as XLF’s 88 million.

Despite normally slow volume during this holiday week, XLF is on pace to top its daily average.

Amid Turmoil, ETF Firms Bring Out New Funds

Well it seems that even amid the turmoil in the broader market and the closing of funds in the ETF industry, new funds are launched every week. Over the previous two weeks, we’ve seen a new airline ETF from Claymore Securities, State Street Global Advisors and BGI both launching two new bond ETFs and Barclays Bank launching two new exchange-traded notes.

This week, Van Eck Global’s ETF family, the Market Vectors, launched two funds. The Market Vectors High-Yield Municipal Index ETF (HYD) launched today on the NYSE Arca, following on the heels of Tuesday’s launched, the Market Vectors Pre-Refunded Municipal Index ETF (PRB) with an expense ratio of 0.24%

HYD will track the Barclays Capital Municipal Custom High Yield Composite Index. This high yield index is a market-size weighted index comprised of publicly traded municipal bonds covering the high-yield long-term tax-exempt bond market.

Van Eck says PRB is the nation’s first ETF to focus on the pre-refunded segment of the municipal bond market and will track the Barclays Capital Municipal Pre-Refunded—Treasury-Escrowed Index. This market-size weighted index holds publicly traded tax-exempt municipal bonds. The unique part about it is the index is comprised of “pre-refunded and/or escrowed-to-maturity bonds.” Heather Bell of Index Universe describes the bonds this way: “Say a city issues $100 million worth of bonds to fund a water facilities project. A few years ago, the deal came to market with interest payments to investors of 6%. But now, with interest rates for 30-year triple-A munis hovering around 5%, the city decides to cut its costs. So it reissues more bonds at the lower rates covering the exact same project. The municipality then takes the proceeds from that second issue and buys similar-termed Treasuries. Since most munis have call features prior to maturity, the Treasuries are put in an escrow account to fully fund the interest and principal of the munis on their first call dates.”

I will address the new ETNs in a later posting.

RevenueShares Launches 5th Fund

RevenueShares Investor Services launched its fifth ETF under the family name RevenuesShares. The RevenueShares ADR Fund ETF (RTR) tracks the RevenueShares ADR Index which holds the same securities as the S&P ADR Index, but re-weights the constituent securities according to the revenue earned by the companies. ADRs, or American depositary receipts, trade in the U.S. but represent shares of stocks that list in foreign markets.

The ETF provider, which launched its first three ETFs in February, uses an innovative index strategy, that, not surprisingly, weight indexes by revenue instead of market capitalization. This follows last week’s launch of the RevenueShares Financials Sector Fund (RWW). That ETF tracks the the S&P 500 Financials Index, but rebalances it according to revenues.

“Rebalancing by revenue offers less exposure to the impact of inefficiencies that occur in a market capitalization-weighted index, while adding the potential for excess returns,” said Sean O’Hara, president of RevenueShares Investor Services, in a press release. “We believe strongly in the buy low, sell high philosophy and RWW is coming out at a time when we believe the sector is near all-time lows. It is contrary to what many other fund companies might offer at this time.”

RevenueShares follows a trend in the ETF industry in which new fund providers must created innovative indexes with the goal of beating market benchmarks in order to garner investor interest and assets. The RevenueShares aren’t the first ETF sponsor to use revenues, or any fundamental metric, as a basis for index weightings. Research Affiliates created the first fundamentally-based index, the Research Affiliates Fundamental Index, or RAFI, in 2005. It’s based on four fundamental factors, of which one is revenue. PowerShares launched the first RAFI-based ETF, the FTSE RAFI US 1000 Portfolio (PRF), which tracks 1000 large-cap stocks, the same year. There are now 22 FTSE RAFI ETFs. WisdomTree also uses fundamentals as the basis for its indexes, but these are weighted according to dividends. Spa’s MarketGrader ETFs chooses index constituents based on fundamental metrics, but uses an equal weighting instead.

Since their February 22 inceptions, the net asset values of the RevenueShares Large Cap Fund (RWL) has fallen 10.6%, the RevenueShares Mid Cap Fund (RWK) has dropped 10.2%, and the RevenueShares Small Cap Fund (RWJ) is down 4%.

Including today’s listings, NYSE Arca has 641 primary ETF listings, 84 ETNs and 25 certificates. Total exchange traded products listed on NYSE Arca represent 61% of ETF and ETN assets under management in the U.S., or nearly $304 billion.

Where Does Short Ban Leave Short ETFs?

Where does the short-selling ban leave the ETFs that short the financial markets?

ProShares Financial ETFs resumed trading just around noon, after a two-hour halt in the shares of both the Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF). At 9:33 a.m., the American Stock Exchange halted trading in the UltraShort ETF after it tumbled $22.44, or 19.4%, to $93 and the Short ETF fell $5, or 8%, to $66. Trading in both resumed about 11:40 a.m.

The sharp decline was a direct result of the Security and Exchange Commission’s early Friday ban on the short selling of financial stocks. Short selling is when investors sell shares first in the expectation that they can buy them back later at a lower price. The ban prevents the shorting of 799 financial stocks. CNBC later reported that General Electric and CIT might be added to the list.

The ProShares ETFs give investors the opportunity to short the financial sector in one trade through a long instrument, or as the company says, buying long to go short. The Short ETF gives the inverse return of the Dow Jones U.S. Financials Index and the UltraShort tries to give investors double the negative return on a daily basis.

It appears the halt was caused by ProShares refusal to create new shares. After trading resumed ProShares released a statement saying because of the SEC ban on short selling it did not “expect to accept orders from Authorized Participants to create shares until further notice.” Shares will continue to be redeemed. However, the company added that these shares “may trade at prices that are not in line with their intraday indicative values.”

Ironically, the ProShares ETFs should be a great way for market players to short the financial markets in the wake of the SEC ban, but the halt and the decision, or inability, to issue more creation units throws this into doubt.

ETFs are like mutual funds in that they are both open-end investment companies. They create shares when demand increases and they redeem shares when demand drops. The difference is the mutual fund sells its shares directly to individual investors, but ETFs only sell shares to brokers, dealers and market specialists called Authorized Participants, or APs. The specialist needs to buy all the shares in the index, then trades them with the ETF for an equal number of ETF shares. This is called the “creation unit”. The trade is called the “in-kind trade,” because it’s shares for shares. The AP then sells the ETF shares on the stock market to investors like you and I. If there’s more investor demand for shares of an ETF, the AP will buy the stocks to trade for more ETF shares, then sell the new shares into the secondary market in the hopes of making a profit.

However, ProShares short funds don’t hold the stocks or short the stocks in the indexes they track. They hold futures contracts that short the indexes and swap agreements. Swaps are contracts between two parties, in this case the ETF provider and a counter party, to exchange a revenue stream. According to ProShares May 13 annual report, the UltraShort ETF held swap agreements equally 200% of its net assets.

Bob Pisani on CNBC said early this morning that with the short restrictions it’s harder for the counter parties to satisfy their obligations. “With restrictions on the short side, firms either cannot provide the swaps or the price of providing them has increased dramatically because dealers who sell the swaps hedge by shorting.” Pisani added that there are now fewer counter parties available. He said there were just four.

As of May, those four were Bank of America, Credit Suisse, J.P. Morgan Chase and UBS Warburg and Lehman Brothers. But Lehman went bankrupt on Monday and its demise left ProShares scrambling to find someone to take on those swaps.

So, if the cost of the swaps goes way up, the only way to hedge is to charge far more for the hedge option. This could significantly increase the costs on these funds, which already charge the extremely high expense ratio of 0.95% annually.

IndexUniverse reported an interesting tidbit. It said the Rydex 2X Inverse Select Sector SPDR Financials (RFN) ETF, which also gives a negative 200% return, traded even as the ProShares ETFs were halted. Rydex said its creation/redemption mechanism continued to function normally. IndexUniverse attributed this to RFN using mostly options to gain exposure to the financial market instead of swaps. Historically, swaps have given investors a more efficient way to track the market, but the deleveraging of swaps has been a large component of what is gone wrong with the financial markets this week. And the short-selling ban has only exacerbated that. Meanwhile, the options market continues to function normally.

So, where does that leave the ETFs that short the market? Will they give short sellers the necessary outlet they need to short the markets? Doubtful, because in the end, the funds try to give investors the return of the index. And the index won’t fall much if the component stocks don’t fall much. And the components won’t fall much because, well, they can’t be shorted. However, this shorting ban puts an artifical floor on the financial sector, and the broader market in general.

The first question to ask is can this ban become permanent. Doubtful. There are too many institutional investors that rely on shorting and this essentially removes from them a significant way to hedge their positions. So, if the ban will be removed, what happens when the SEC removes it? Obviously, it’s a big unknown, but if the values are not there and today’s rally is on false pretenses, the shorts could come back and put significant pressure on the market. And when one considers how this came about with no warning and totally screwed all the short sellers, they will be out for revenge. Cold blooded revenge. And you may see the worst market decline since 1929. If that happens. These next two weeks may give investors a nice opportunity to pick up the SEF, SKF and RFN at a low price amid low volatility and just wait for floodgates to open. Geronimo!