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The China Syndrome – Are ETF Investors Buying A HOG In A Poke?


Ready To Rumble? – ETFs: How Not To Regulate

Intelligent Design

If we did ten things, and nine were bad and were disclosed by the newspapers, we would be over.

          - Mao Zedong

Invesco, the managed money giant with a reported $403 billion under management, is well known for its PowerShares ETFs.  Under their registered promotional announcement, according to their website, they are “leading the intelligent ETF revolution.”  Just how “intelligent,” we are now finding out. 

We have been casting about for a fitting metaphor for ETFs.  Now we believe we have one: ETFs are the financial markets equivalent of Intelligent Design.  Intelligent Design proponents bamboozle their way into the dialogue through the ruse of misappropriating a term of art, and repackaging it in its common usage.  They say that the Theory of Evolution is “only a ‘Theory’”, which therefore must be forced to yield the floor to other “Theories.”  By taking the word Theory – used in its scientific meaning as a commonly-accepted mechanism which, though perhaps not fully understood, is widely agreed to contain basic truth about how a phenomenon works – and putting it into its common usage, where it means “something we’re not quite sure about at all, but we hope it might explain some of what goes on”, they undermine the debate, grab headlines, and so far have managed to come perilously close to forcing their will on the nation.  The fact that they manage to be taken as serious debate partners at all is a testament to the rampant ignorance of a nation that would rather read Twitter than Dickens. Not that we are measurably worse in that department than most other cultures – but this happens to be the culture in which we live, work and pay taxes, and so our country’s foibles strike closer to the heart.

In a parallel testament to the ignorance of the investing public, and of those charged with protecting them, ETF issuers have achieved the mass retailization of a sophisticated institutional product, right under the noses of the regulators.  Gee, who’d a’ thought?

These are “Funds” that “Trade” on an “Exchange.”  That makes them securities.  And since they trade in units called “Shares”, and since their shares trade on exchanges and are bought and sold in a two-sided market, they are really just like common stocks.


In a rare and marvelous exercise of backwards-think, the regulators managed to convince themselves that ETFs walk like anything but a duck.  Rather than viewing ETFs as a single-share unit instrument that actually comprises a synthetic contract used in sophisticated, algorithm-driven arbitrage programs, regulators have benignly treated ETFs as nothing more than misunderstood common stocks.  The investing public was duly led to the trough, with the result that a fair number of them have been scratching their heads at instruments that appear to be tracking something very different from the indexes they were supposed to be tied to.

Now, just when we thought we had seen it all, our detector has come across yet another potential land mine in the investors’ portfolio.  (Actually, we do not think we have Seen It All.  The creativity and genius of even minor scam artists is astonishing – to say nothing of the frenzied gullibility of the investing public, who literally have wagered their own lives and the lives of their children yet unborn on nonsense as diverse as tulip bulbs, international postage coupons, and Bernie Madoff’s decades of “too good to be true” steady market-beating performance.)

A product which may be far more “revolutionary” than Invesco realized is the PowerShares Golden Dragon Halter USX China ETF, a mouthful whose ticker symbol is PGJ.  Launched in December of 2004, the fund seeks to replicate the return “of an equity index called the Halter USX China index(SM). The fund normally invests at least 80% of total assets in equity securities of companies deriving a majority of their revenues from the People's Republic of China.”  (Yahoo! Finance)

The Halter China Index was created by Tim Halter, head of Halter Financial Group.  This fact was not immediately obvious because the website for Halter Financial does not feature a drop-down titled “Management”.  Indeed, we searched in vain for anyone’s name on the website.  We admit to being technologically behind the times, and impatient to boot, but it struck us as odd that the founder of a firm that bears his own name would not feature himself prominently on his own website.

Another odd item: Halter’s website has two URL addresses.  One is “halterfinancial.com”.  The other is “reversemerger.com”.  Halter has built a specialty niche business taking Chinese companies public in the US market by merging them into public shells.  They have even trademarked a concept they call the Alternative Public Offering – a combination of a reverse merger and a PIPE capital raise.

So far, so creative. Halter’s website describes their on-the-ground approach to Chinese investing – they opened an office in Shanghai in 2002 – and proudly lists the companies they have brought into the public marketplace in the US.  A peruse of this list, cross-referenced through Google, turns up one or two tidbits that we found curious.  We hasten to point out (our lawyers will like this) that we are not accusing Halter of any impropriety.  But the structure of their fund raises potentially troubling questions for ETFs in general.

Among the quaint features that emerge is an apparent nexus between Halter’s activities and a gaggle of smaller Texas businesses (Halter is based in Dallas) including a leather factory, a building contractor, and a female bodybuilder who is apparently somewhat successful on the local circuit.

In September of 2005, Strong Techincal, Inc filed an SEC Form 424B3,  disclosing that Halter Capital Corporation had acquired a controlling interest in Strong’s shares (82.4%) and that all previous business activities of Strong Techincal were discontinued, thus creating a public shell.

That company – renamed Zhongpin – now trades on the Nasdaq under the symbol HOGS.  Yahoo! Finance reports it closed on Friday 21 August at 11.37, down fractionally on the day, on volume of over 255,000 shares – late-August trading no doubt partly responsible for the volume coming in substantially shy of their three-month average of over 326,000 shares (all data taken from Yahoo! Finance).  The Top Mutual Fund ownership data available lists PowerShares Golden Dragon Halter ETF as number eight out of the top ten fund holders of Zhongpin shares.  The position shown on Yahoo! is only 79,000 shares, or 0.29% of the total outstanding.

We wonder about the activities of a financial firm that takes Chinese companies public through reverse mergers, then puts those same companies into an index it manages, which may automatically require those shares to be purchased by an ETF tied to its index.  ETFs are required to post positions, but not all of them.  The prospectus we found on the PowerShares website lists the top 30 positions in the Golden Dragon ETF (ticker PGJ).  Needless to say, at a market value of some $650,000, PGJ’s position in HOGS is not material to either HOGS itself (market cap in excess of $330 million) or to the ETF.  Neither HOGS nor PGJ, with reported assets in excess of $383 million, will not feel a ripple from a fluctuation in a position of that size.

On the other hand, due to the opacity of the lower capitalization end of the ETF structure, we have no way of knowing how many of Halter’s own reverse mergers may be held in the ETF managed based on its index.  Membership in Halter’s China index requires only a $50 million market capitalization.  This permits highly illiquid securities to be included in the Index, and thus bought for the ETF.  A quick comparison of Halter’s own website – which lists tombstones for a number of their deals – with the Halter USX China Index website reveals that a number of the companies held in the Index were Halter deals.

As we have previously noted – see last week’s discussion of natural resources ETFs – creation and liquidation trades rely on instant liquidity.  It is entirely possible that a fund such as Golden Dragon would seek to satisfy its liquidity requirements by trading the top tier of its most liquid stocks, while not touching the essentially illiquid shares in its basement.  Indeed, selling out of stock for which there is not a sufficient bid might be deemed not in the interest of shareholders of the fund.  Thus, if Halter were in fact to put their own illiquid reverse merger stocks into their Index – and they were then bought into the ETF – this could have the effect of permanently locking away a portion of the float.  Or of creating liquidity for sellers in an otherwise illiquid market.

In any event, the fund would likely not be out of those positions for long.  The Golden Dragon ETF’s assets appear to have climbed substantially this year as China gained investor visibility.  Our very inexact eyeballing of their figures indicates their assets are up by more than a third since the first quarter.  An insignificant million-dollar trade for a fund approaching $400 million in assets could have a meaningful impact on the shares of a company with only $50 million in capitalization.

We are hardly the first ones to note this phenomenon.  An article appeared in Barron’s a couple of years back (28 October 2006, “China Funds’ Shell Game”) which contains the following paragraph:

“Barron’s review of the index unearthed conflicts that ought to give fund investors pause.  The shares of at least one of these companies rose in value after entering the index, but as the stock gained, Halter and his family were selling.”

For all the digging Barron’s claims to have done, the article makes for fairly tepid reading and fails to come up with a smoking firecracker.

Frankly, while we are mindful of the potential for abuse in a set of small, interconnected businesses, we would rather not see regulators spending inordinate amounts of time going after the Halter Financials of the world.  While we have no concrete evidence to suggest they are doing something they should not, the fact that they have rolled into their own Index shares of companies for which they were the banker, and that those shares are now bought by an ETF based on that Index, doesn’t pass our smell test.

A read through the PGJ prospectus, available on the PowerShares website, does not mention that Halter is the banker for a number of companies held in the Index.  If, as Barron’s indicated, there are Halter personal or family holdings of any of these issues, it appears not to be disclosed.

We believe all this to be legal, by the way, which is an indictment not of Halter and their business, but of a legislative and regulatory regime that actively promotes the cloaking of critical information. 

Indeed, Halter Financial may legitimately have a different problem, which is the appearance of conflict of interest by virtue of having succeeded.  If, in fact, they really did set up a Shanghai office, get to know local businesses, gain tremendous insight into the Chinese economy and marketplace, win the trust of local business leaders and government officials, and create an unassailable niche in the US securities markets by bringing Chinese companies public with a minimum of expense – if so, then Halter may be a victim of their own success.  If they have in fact done all this, Halter may be the only firm that truly understands its markets.  If so, they may find themselves faced with a dilemma: to put their own companies into their Index – trading names they know intimately – or step back from that and go with lesser quality issues.

If so.  And if not…

The SEC and Congress are apparently not troubled by the fact that investors can take a shot on an index, while simultaneously creating liquidity for entities with an undisclosed direct interest in that index.  Undisclosed, we repeat, because it is not required to be disclosed.   We wonder what lessons PGJ’s bigger siblings have drawn from this.  We fear the flap over the CFTC wanting to limit commodities trading by ETFs may be the tip of an iceberg – and the wrong iceberg, at that.  We invite the CFTC to look into links between ETF managers, the traders who fill their orders, and the downstream interests that stand to gain as contracts or physical commodities are bought and sold.

We would invite FINRA and the SEC to do the same – except they have clearly already looked at this structure and determined that everything’s cool.  ‘Cause otherwise, well you just know they would do something about it.

Intelligent Design?  We call it downright Brilliant.

Dumb Design

I have a very strict gun control policy: if there’s a gun around, I want to be in control of it.

                   - Clint Eastwood


Followers of market statistics have noted a record divergence between the price of oil and that of natural gas.  This week, market watchers were also treated to the news that “A hedge fund has made a large, eye-catching bet that natural gas prices will triple…” (Financial Times, 20 August, “Fund Bets Millions On Tripling Of Gas price”).  Taking a moment to parse this story, we wish to point out that the purchase of six month, out of the money call options does not mean that the buyer is betting gas prices will reach or exceed the strike price.  For a newspaper of the stature of the FT to suggest otherwise is sloppy reporting, at best - or fear mongering (could the FT be long natural gas?).

That being said, we think it worthy of note that someone is scooping up January and February contracts at the same time that the CFTC is clamping down on ETF trading in the underlying commodity. 

As we have predicted, the price of the natural gas ETF – the now notorious UNG – has diverged sharply from the underlying commodity.  The Wall Street Journal (22 August, “Small Investors Face Big Hit In ETF Push”) reports “UNG is trading at a 16% premium to gas futures because investors are willing to pay extra for the ability to expose their portfolios to the commodity.”  The article quotes UNG as stating they already own “about a fifth of certain benchmark gas contracts.”

The same WSJ article discusses the CFTC’s stated objective of protecting end consumers of the commodities in question.  Restricting ETF access to these markets will have the effect of raising expenses within funds, even as their investable asset base becomes limited to funds on hand.

The Journal article points out that these once-proud ETFs will then trade more like closed-end funds which, as the article says, “would render the instruments less desirable, because prices of the shares of closed funds tend to deviate from price moves in the underlying commodity.”

How are the mighty fall’n!

It would appear that, in their zeal to protect the consumer (read: the people buying natural gas for industrial use) the CFTC is whacking the consumer (read: the people who invest in ETFs for portfolio diversification, or as a commodity hedge against stock market declines).

Enter CFTC commissioner and long-time Washington pro Bart Chilton.  “The Commission has never said ‘You aren’t tall enough to ride,’ Mr. Chilton said.  “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation – intentional or otherwise.”

This has all the makings of a World Wrestling Federation Smackdown Tag Team free-for-all.  In one corner, the Feds are fighting amongst themselves over who gets to regulate the markets – like in the world of pro wrestling, being on the same team doesn’t mean you don’t also make it with each other’s guys when the other woman’s back is turned.  CFTC Chair Gensler is applying the hair-pull to SEC Chair Schapiro, stepping up to regulate the untamed ETFs – which, since they are “shares” that “trade” on an “exchange” might actually be the bailiwick of the SEC, watchdog of the securities markets.

In this corner, the ETF industry – a team of musclebound giants who always charge their opponents in unison.  They never bother to tag up, they just all jump into the melee together.  When you are that big, the referee doesn’t challenge you.

Stuck in between all this sweat and spandex and steroid-generated muscle, the investor is staggering dazed around the canvas.  We may not be tall enough to ride, but we are apparently big enough to get tossed repeatedly from the back of what was sold to us a the gentlest horse in the stable.

Commissioner Chilton refers to “manipulation – intentional or otherwise.”  We always thought that manipulation required intention.  We carry no license to practice law, but we think if ou are a victim of your own success, then you keep taking advantage of market inefficiencies until you – or someone else – chokes.  Then, goes the theory, the inefficiencies go away and you have to come up with something else.

If it is “otherwise” – i.e. not intentional – then it is not manipulation.  For a senior regulator to make such a clearly false statement looks like a danger signal.  The CFTC is not out to regulate improper, or excessive trading in the instruments it oversees, but is out to “fix” the marketplace.  This, of course, is the ultimate in manipulation.  

Still, we recognize that Chairman Gensler is in a bind.  The SEC won’t do its job of unknotting the relationships in the ETF world, to make sure the engine runs clean.  The SEC can not step in and regulate the commodity or futures markets, and they apparently will not force full and transparent disclosure on the ETFs, nor have they acknowledged strongly enough the fact that ETFs frequently do not do what they are supposed to.

Investors can not clean up the market.  The theory of market efficiency presupposes that someone out there wakes up one day and recognizes that things are not working out as advertised, but surely we all recognize that it doesn’t work that way.  With fifty million adult Americans functionally illiterate – and with the ones who can read working either on Wall Street or in Washington – it should be clear by now that this B-School theory looked great on paper (assuming you were one of the minority of Americans who could actually understand what it said), but that it won’t work in reality.

Gensler, Schapiro, Chilton et all – they all have their political masters to serve.  We are not worried about Gensler – a former Goldman partner – and Chilton has deep roots in both the farm lobby and the Washington establishment.  Neither of these gentlemen will worry about where their family’s next meal is coming from.

Chairman Schapiro, on the other hand, still has a tough row to hoe.  She constantly risks being tarnished with the Madoff brush, should anything big come up on her watch – and she’s getting precious little help from the Obama Administration.  Rather than standing up to Congress and making them give the SEC substantial new resources, President Obama appears to be using Schapiro to advance a political agenda aimed at giving trade unions the ability to interfere directly in the management of companies they work for.  We thought one shareholder, one vote was a fine idea.  The problem is that, when pitting the labor unions against entrenched boards of directors and mega-star CEO/Chairmen, it is difficult to ascertain who is more corrupt and less capable ofr actually making an intelligent business decision.

While all this is going on, the financial titan tag teamers continue their time and continue to suck up assets until the Next Big Thing comes along.  By the way, once ETFs are no longer the flavor of the month, bet on all the big managers filing to change their fund structures.  This will no doubt be a satisfactory solution and will be announced as a triumph for the investor.  The best way to make bad securities go away is to pass a law saying that they are now good securities.  This will get the masses to put down their pitchforks for at least a fortnight, and serves the politically important end of making it look like the SEC and CFTC have accomplished substantial change, without either entity actually having done anything.  We watch for ETFs to start to convert to some now fund structure, with the joint blessing of the SEC and the CFTC.

Meanwhile, this monumental brawl looks even less like WWF Smackdown, and more like a desperate barroom fight where someone has dropped a pistol.  Everyone is clutching at the gun.  Sooner or later, it’s bound to go off.

Moshe Silver

Chief Compliance Officer