The Tail That Wags the Dog

By: Rob Kirby | Sun, Feb 19, 2006
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Since 1993 - when the first exchange traded fund, The Spider, was launched - this type of financial instrument [ETF or Index Fund] has grown dramatically in popularity,

ETFs are funds that trade like stocks. More specifically, they are index funds that trade on the open market. They offer a lethal combination of extremely low cost, versatility, and diversification in a package that costs the exact same amount to buy as a normal stock trade. ETFs track nearly every index you can imagine: the S&P 500, the Dow Jones Industrial Average, the Wilshire 4500, bonds, countries, industries, and sectors. Expenses are minimal, and they are generally transparent because they are deducted from dividends payable to investors. What's not to like?

ETFs have risen in popularity for a variety of reasons. Those most often cited are the following:

Low-cost investing : Annual expenses range between 0.1% and 0.65% and are deducted from dividends. The only other fees associated are the trading costs at your brokerage.

Tax-efficient: Indexes have much lower turnover than the vast majority of actively traded funds. And by construction remaining investors do not inherit tax liabilities due to others' decisions to sell.

Time-efficient: Many investors do not wish to pore over annual reports and would prefer a more passive approach. Due to their relative diversity, ETFs are ideal for investors who lack the time or inclination to select individual stocks.

Historic performance: This advantage varies as the number of ETFs and their benchmarks skyrocket. But according to statistics complied by Burton Malkiel, Spiders, the most widely held ETF, have returned on average 3% per year better than actively managed mutual funds since inception.

Flexibility: An ETF may be traded anytime the exchanges are open. Open-ended mutual funds can only be redeemed at the closing price of the day. Further, ETFs can be shorted, optioned, and margined.

In case you're not aware, there is a basket of 12 relatively dominant [liquid] gold and silver miners [equity shares] that constitute the core of both popular gold indexes - the XAU and the HUI. In each case, 4 additional equities distinguish the difference between the two indexes - each having 16 members. The XAU is widely viewed as having members who generally [but not necessarily] hedge their production and the HUI is generally referred to as having members that generally do not hedge production beyond 1-1/2 years.

The indexes are calculated to support various index-based products such as ETFs, index options, and structured products.

Both the XAU and HUI are arithmetic indexes. The XAU is a creation of the Philadelphia [PHLX] Exchange while HUI was created by the good folks over at the AMEX [American Stock Exchange]. The following discussion examines the interplay and differences between the arithmetically derived indexes and the highly leveraged options based on them.

The current composition of the XAU and HUI indexes are as follows:

Philadelphia Freedom

People should understand that the dollar volumes spent on XAU index options in particular - are not only highly levered but notionally immense. As we learn right from the Philadelphia Exchange web site:

"XAU is the most actively traded Gold & Silver index for retail and institutional investors in the marketplace today as well as the seventh most traded index option in the US during 2005. Today's changes reflect a growing trend by Gold & Silver mining companies to allocate resources to properties for rehabilitation and full-scale exploration," said Daniel R. Carrigan, PHLX's vice president of new product development. "The new components reflect leadership changes in the Gold & Silver industry on a geographic basis with penetration in Russia, Australia, South America and Eastern Europe," added Carrigan.

When considering the world of index options, you are entering the world of arbitrageurs and program trading. Here, large volumes of securities change hands very quickly to capture price differentials between synthetic [option or derivative] prices and the actual cost of the underlying good in its cash market:

Because the financial products sold in the futures and options markets are derived from an underlying cash product -- in this case stocks -- their prices are mathematically related. This mathematical relation is no more mysterious than the relation between the price of a six-pack of root beer and the price of a single can. When one price falls relative to its mathematical relation to the other, index arbitragers can buy the cheaper product, sell the other one, and lock in a gain. That's what index arbitragers do whenever buying or selling by other traders causes futures or options prices to move too high or too low relative to underlying stock prices.

XAU options trade described above amounts to massive bets on the fortunes of 16 mining companies that make up the XAU index with an underlying or collective market capitalization of about 116 billion dollars.

To give this some context, consider that the PHLX Semiconductor Sector [SOX] Index is composed of 19 companies with a combined market cap of more than 375 billion - yet, dollar value of traded SOX index options is dwarfed by trade in the relatively "less capitalized" underlying XAU basket as illustrated by a couple of random PHLX daily index option volume totals here and here.

The evidence above demonstrates that a disproportionate amount of dollars is chasing the relatively "less capitalized" basket of XAU equities - in a highly leveraged pursuit - in a sector that's widely disparaged, but yet, has done nothing but go up for the past 6 years and which virtually every major Wall Street brokerage perennially rates as "A SELL" or "UNDERPERFORM"? Hmmmm.....

Applying some Newtonian Physics - we know these large volume option trades spawn buying or selling a basket of underlying securities - ie. Computer or program trades. The big dollars involved imply that the players have deep pockets. But given that we've identified this activity as highly risky - what about motive?

Compliments: Adam Hamilton

Over the past 6 years, the bottoming and subsequent rise in the price of gold has been perfectly correlated with the dramatic increase in equity index option trade and corresponding and simultaneous rise in program trading on the NYSE. In the year 2000, when the technology bubble burst, equity index trading [a root cause of program trades] began to surge,

In 2000, the PHLX set new volume records for both equity and options trading. More than 72 million equity options contracts traded as compared to 44 million the previous year. PHLX equity volume reached 2 billion shares in 2000, up from 1.5 billion in 1999.

Now consider that back in the year 2000, program trading amounted to no more than 20% of daily NYSE volume. Today it is customary to have computers account for 55 or even 60 or more % of NYSE daily volume.

Two-Fold Tale

The increase in equity index spurred program trade has most assuredly been utilized to buoy, or create a floor in sectors such as the NASDAQ while capping any "budding" excitement or developing fervor in the mining or precious metals sector. This is one credible explanation [perhaps the explanation] of many late day "hail mary" rallies that have been experienced over the past 2 - 3 years - when DOW and NASDAQ Indexes have made incredulous late day rallies apparently mitigating waterfall index events. The reverse of this is so often evident to stem rises in the precious metals complex as evidenced by Bill Murphy's [GATA] often cited "6 dollar rule".

Amazing, isn't it, how PHLX option index trading has advanced commensurately with gold's price advance since the historic signing of the Washington Agreement in the fall of 1999. The same time frame - late 99 - 00 - is also coincidental with the re-ignition of the precious metals equities sector after years in the 'dumper' due largely to the fallout of the Bre X scandal in the 90's. Noteworthy - and against this backdrop - we have GATA's consistent claims that gold's relentless, now 6 year price rise has been surreptitiously capped the whole way.

Resolving Big Dollars, Big Risk and Motive

You see folks, the gold share prices have to be contained at all costs. As GATA's Bill Murphy is so fond of saying in his daily Midas column, "market action makes market commentary". In this sense, rapidly rising gold or precious metals shares have the ability to capture the excitement and the imagination of traders and investors alike - and thus price rises must be contained or capped - just like gold and silver futures are capped by the usual crowd of suspects - bullion banks - on the COMEX and TOCOM exchanges. GATA's views about gold price suppression have recently been endorsed by none other than French banking giant Credit Agricole's brokerage unit - Cheuvreux - in a 56 page research report. Put simply, gold is and always will be viewed by spendthrifts in officialdom as the enemy of un-backed fiat currencies - period.

Flexibility, Fleas or Fleeced?

Anecdotal evidence suggests that support, through purchase of equity index options and futures, is lent to the "chosen sectors" - like the SOX - falsely showing the economy is robust or strong while the opposite tactics [sales] are used to cap the "undesirables" - namely, gold and/or precious metals. All of this frenetic activity is "neatly hidden" behind curtains, conducted by 'chosen agents' who, in turn, make Sachs of money. This all occurs right under regulator's noses - but we all know and remember that Mr. Greenspan had a persistent habit of vocalizing his support to keep derivatives in the realm of "the unregulated" - citing the flexibility all this affords the financial system. For all Mr. Greenspan's musings about the financial system needing more flexibility, he was really articulating in "Greenspeak" the current state of affairs - one where our 'dog of a financial system' is now wagged by its derivatives tail.

Whether or not Ben Bernanke scored 1590 out of a maximum 1600 on his SATs, has an economic degree from Harvard and a doctorate from Princeton will - in the end - perhaps prove to be interesting but ultimately trivial lore. The labyrinth of deplorable decisions, deceptions and inexplicable events - all spun as appropriate policy, conundrums or coincidences - that precede him; they all reek of what appears to be the entrails of MASSIVE PREMEDITATED PRICE FIXING SCHEME, which in this case has a particular twist that winds its way through the City of Brotherly Love. Can't you feel it? Isn't it wonderful to wake up and find out the loveable dog of a financial system we've all been sleeping with has fleas - and now we do too?


Rob Kirby

Author: Rob Kirby

Rob Kirby
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