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Just Walk Away From Credit-Default Swap ETFs

Retail investors can bet on CDSes via funds ... but shouldn't

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It’s no secret that we here at InvestorPlace love exchange-traded funds (ETFs). These baskets of stocks, bonds and other assets have leveled the playing field for regular retail investors.

Corporate BondsETFs allow us to get broad core positions on the cheap, make calculated bets on various sectors and even get access to some sophisticated asset classes, such as commodity futures or hedge fund-styled strategies.

But that doesn’t mean we need an ETF for everything.

In fact, a pair of recent fund launches from ProShares provide great examples of products that can be more harmful than helpful to average Joes.

You Can Be the Next John Paulson!

Just when you thought that every class was covered by an ETF, ProShares comes out with a pair of funds that covers something new … and potentially diabolical.

These ETFs give us the ability to buy and sell credit-default swaps (CDSes).

At its core, a CDS acts very much like an insurance policy. An investor buys protection to hedge the risk of default on a bond or other debt instrument. So if you think XYZ Inc. will default or has a chance to default on its bonds, you purchase a swap that will pay you in the event that it does.

In short, if you’re buying a potentially risky IOU, CDSes come in handy.

However, the similarities to an insurance policy end there.

The kicker is that investors in CDSes don’t have to hold or have any interest in XYZ’s bonds. The credit-default swap can therefore be used to speculate on various debts. And they do. More than $8 billion of CDS trade hands every day. That’s more liquidity than the high-yield bond market itself.

Secondly, swaps can be written by anyone — even those firms from outside a regulated entity. And sellers are not required to keep any sort of reserves to cover any CDS they’ve written.

So a CDS really is insurance that comes with a bit of risk themselves — it can be lucrative, but it can also be extremely dangerous.

If you remember, credit-default swaps were a part the alphabet soup of various securities and derivatives that basically helped spur on the credit crisis and late-aughts market crash, and what helped force insurer AIG (AIG) into needing a bailout from the U.S. government during the recession.

However, several hedge fund managers like John Paulson made billions on swaps tied to the housing market and subprime mortgage loans — essentially huge bets against these markets — which is why they still have some allure, and which is why ProShares is bringing a couple new products to market.

OK, These ETFs Won’t Actually Make You the Next John Paulson

Alternative ETF issuer ProShares is now offering ETFs that bet on credit-default swaps: the ProShares CDS Long North American High Yield Credit ETF (TYTE) and the ProShares CDS Short North American High Yield Credit ETF (WYDE). Moreover, ProShares has six more CDS funds in registration that will bet on other aspects of the bond market.

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