My, how investors love derivatives. At first it was short ETFs, and then it was double long ETFs and double short ETFs. Recently, they have introduced triple long and triple short ETFs.

Counter-Party Risk

A derivative is a contract with another party that causes money to change hands depending on the future value of some asset such as interest rates, stock prices, or currency values. A futures contract is a derivative.

If you hold a derivatives contract, then the guy on the other end of the trade is known as your counter-party. Unless the derivative contract is collateralized or otherwise guaranteed, you are dependent on the creditworthiness of the counter-party. A derivative is like an IOU.

Simply put: if the guy at the other and of the trade is bankrupt, he may not honor your derivatives contract. In the 2002 Berkshire Hathaway (NYSE:BRK.A ) annual report, Warren Buffet wrote about the significant systemic counter-party risk:

Many people argue that derivatives reduce systemic problems, in that participants who cant bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

ETNs

Many Commodity Index Funds and leveraged funds are structured as Exchange Traded Notes (ETNs). ETNs do not represent physical holdings, they are contracts with the note issuer.

During the global financial crisis, Lehman had backed a large number of ETNs and if they went bankrupt could default on their ETNs. Unlike ETFs, the much riskier ETNs expose the investor to a further layer of counter-party risk.

An ETN consisting of derivatives exposes the investor to the counter-party risk of the underlying derivative contracts, wrapped in the counter-party risk of the ETN vehicle.

Despite the recent meltdown, there is still a huge amount of outstanding derivatives. System-wide counter-party risk is still an ominous threat.

Oil ETNs/ETFs

Clever fund sponsors have created ETNs and All is not well in the oil derivative patch, as an earlier article Lee Munson e xplains the performance of three exchange-traded products OIL (NYSE:ETN ), USO (NYSEMKT:ETF ), and DBO (ETF ).that supposedly profit from the up and down movements of oil futures. Lee was dismayed by the products’ performance during a period in which oil futures had risen 85% (February 08 to May 09), as Lee Munson writes:

Lets cut to the chase. Just get your charts out and compare the three ETFs since the February bottom. I cant make this stuff up (to my dismay since I own OIL and looking to sell as I type), and the percent gains are 38%, 34.4%, and 40.8%. This is a far cry from the 85% in the futures market. This makes me sick. While I am happy I picked the one that is up 38% (like it matters between the three?), I didnt get anywhere near what OIL describes as an index [that] is derived from the West Texas Intermediate (WTI) crude oil futures contracts traded on the New York Mercantile Exchange.

I am here to say today that these three devices do not work as described. Period. This is an incredible disappointment even though the ETFs have gone up over 30% in the last few months. Where is my 85%? In the past, I have suggested to readers to stick with one strategy so as not to get caught in the contango problem but now it seems like it doesnt matter.

Leveraged Equity ETFs

Surely these poor returns can be explained by must be some type of anomaly in the oil patch. Lets see how derivative-based products have fared in the equity patch.

Paul Boyer who writes the Mad Money Machine Blog had a similar epiphany with leveraged equity ETFs. While Im not sure I trust the word of anyone who uses the words mad and money machine together, I think Boyers math is impeccable. It seems that leveraged ETFs are fundamentally flawed in that they change with respect to daily price changes and do not change with the underlying index. No wonder Paul Boyer is mad! Boyer explains it with this hypothetical example in his article Levered ETFs are Toxic. Heres Why .

Leveraged Exchange Traded Funds (ETFs) such as FAZ, FAS, and SKF are designed to multiply the DAILY PERCENTAGE change of the underlying index by factors of 2 or 3. They are thus toxic to your wealth and must not be held. Heres a simple explanation of why. Take the FAS which is the 3X of XLF, the Financials fund. When XLF rises 1% in a day, the FAS is supposed to rise 3%. When things are going your way, everything is fine. But when the XLF drops, very bad things happen to FAS.

Have a look at this table:

On day 1, XLF rose 10% so FAS rose 30%. Great, youre in the money.

But on day 2, XLF dropped back down to its starting price of $10.00, a decline of 9.09%. The bad news is that FAS declined 3X this amount or -27.27%. This takes its share price down to $9.45 instead of the $10 that you might expect.

So whereas XLF is unchanged after 2 days, FAS is down 5.45% after those same two days.

Why? The power of daily compounding instead of cumulative compounding. The leveraged ETFs are structured in a way that they compound on daily percent changes, not cumulative price changes. The day 2 decline of FAS should only be 23.08% to take it back to its original $10.00 per share price. But because it is 3X of XLFs daily change, instead it declines 27.27%.

What Does The Smart Money Say?

Who better to trust than the worlds greatest investor? Speaking on derivatives, in the 2002 Berkshire Hathaway annual report, legendary investor Warren Buffet wrote:

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.

In my view, derivatives are financial weapons of mass destruction. carrying dangers that, while now latent, are potentially lethal.

Summary

The commodities funds Leveraged and Derivatives-Based ETF/ETNs are wealth destroyers and are not suitable for the long-term investor.

Full Disclosure: Author holds no position in any commodity derivative or in any fund mentioned in this article. This article is for informational purposes only and is not meant to be construed as an invitation to invest with any specific strategy or to buy or sell any securities . You should perform your own due diligence and consult with a professional before investing.