We said we'd profile some of the newest filings to come down the pike. True to our word, here's a link to a prospectus that was filed yesterday for four potential new ETFs:

• ETSpreads High Yield
• ETSpreads Inverse High Yield
• ETSpreads Investment Grade
• ETSpreads Inverse Investment Grade

The ETFs are noteworthy in that they mark ETF providers first foray into the world of credit default swaps (CDS). For those of you who are blissfully ignorant of CDS ("blissful" being very much the operative term these days, as CDS-related woes plague the market), they're derivative instruments that function similar to an insurance contract, with one party buying protection and ther other selling it. The insurable "event", if you will, is a credit event, such as a borrower's default on the pledge to repay a debt.

Here's an example: Let's suppose that after buying GM debt, you or I got jittery about the company's financial condition and sought a way to minimize our exposure to the risk that the carmaker would ultimately go belly-up. If you or I buy a CDS, we agree to pay a fee (which you can think of as an insurance premium) in return for the CDS seller's promise to pay us a certain amount in the event GM fails to repay us (think of this as you might a life-insurance payout). In so doing, we hedge away some of our risk, at least in theory. In reality, CDS have become enormously popular in institutional circles, not just as a hedging tool, but also as a way to opportunistically bet on trends or arbitrage opportunities in the credit market. They're a way to bet on credit and credit alone (i.e., no interest-rate, yield curve, prepayment, other risk).

Now, brevity has never been the soul of our "wit". Yet, it took us 200+ words to merely explain how the securities underlying this ETF operate. And we haven't even gotten around to explaining how the ETFs work!

The ETFs above will track indexes that are essentially baskets of CDS (the high-yield and investment-grade indexes contain 100 and 125 CDS, respectively). It will track these indexes by selling (or, in the case of the "inverse" ETFs, buying) CDS contracts that are part of the index. And when the index "rolls" every six-months to update its constituent CDS holdings, then the funds will replace the swaps they own with a new batch.

Here's a relevant excerpt of the Inverse Investment Grade fund prospectus describing how this process works:

The ETSpreads Inverse Investment Grade Fund achieves its inverse (opposite) investment grade credit exposure primarily through CDS Contracts and, under normal market conditions, will enter into CDS contracts with a notional value of at least 80% of its net assets. In order to gain inverse exposure to the investment grade market, the Fund will normally be a net protection buyer, and therefore will be required to make the ongoing payments specified under such contracts that represent the cost of purchasing protection from adverse credit events relating to a Reference Entity.

(Though the prospectus language is unclear, it appears that the funds will invest in "CDX" contracts, which are a type of CDS whose value is tied to a basket of 100 (in the case of the high-yield index) or 125 (investment-grade) CDS contracts. That is, it'll buy a synthetic asset whose value is derived from a basket of synthetics. Hoo boy.)

Here are some of the potential problems we see with this structure:

- Taxes and Transaction Costs: Given that the CDX contracts roll every six months, and considering that the funds intend to purchase "on-the-run" contracts, that means the portfolio is going to turn over a lot. As such, the funds are likely to incur heavy transaction costs and could face a heavy tax hit as well. Institutions don't need to concern themselves with the tax consequences, but retail investors could get absolutely clobbered.

- When Does a Fund Cease to Be a "Fund"? To qualify as a tax-free "regulated investment company" under the Internal Revenue Code, the fund must pass certain tests, including criteria prohibiting ownership of certain types of securities. The prospectus acknowledges that the funds are pushing the edge of the envelope by investing in CDS, stating "The treatment of these derivatives under tests applied in determining qualification as a regulated investment company under the (Internal Revenue) Code is uncertain. The Funds have not obtained an opinion of counsel and there is no definitive guidance concerning the proper treatment of CDS Contracts under the (Internal Revenue) Code provisions relating to qualification as a regulated investment company." What would happen if the funds ceased to be considered regulated investment companies? They'd be taxed as corporate entities, meaning that returns would get dunned twice--once at the fund level, the second time at the investor level. And if you think this is purely academic, consider that PIMCO Commodity Real Return ran into this very problem a few years back. In that case, the fund was using a derivative known as a "total return swap" to capture the returns of the Dow Jones-AIG Commodity Index. When the IRS blew the whistle on the practice, PIMCO management had to scramble to line-up acceptable alternatives.

- Escher-like Complexity: You're talking about an ETF that invests in a synthetic tied to a basket of synthetics which, in turn, derive their value from actual, honest-to-goodness securities (or, at least, events related thereto). CDX and CDS are over-the-counter instruments which, at times, won't trade well. The upshot is that we have serious concerns about the way these securities are priced, the way market-makers will create and redeem ETF shares, and the attendant potential for large bid/ask spreads and disconnects between the fund's market price and NAV. It's the kind of alchemy that seems destined to confuse and disappoint investors.

- Management: The funds' advisor, CCM Partners, manages the "California Investment" series of mutual funds, including a few index funds. As of Dec. 31, those funds collectively held around $600 million in assets. CCM is an unknown in ETF circles, this filing marking their first foray into the industry. While that's hardly unusual--heaven knows there have been plenty of unproven managers testing the waters in the ETF world--we're concerned by the fact that the firm doesn't appear to have a wealth of experience managing money in this style. For instance, a search of the SEC's EDGAR database for the terms "CCM Partners" and "swap" yields not a single result. We also weren't able to find anything more exotic than futures contracts in any of the funds' recent filings. Given the sheer complexity of this endeavor, you'd want to have a very experienced, proven manager at the helm. At a minimum! Yet, compared to the largest indexers, CCM is an infintesimally small player. Further, they don't appear to have much, if any, experience executing a strategy like this one. That's worrisome.

Long story long, these funds look like trouble.

Jeffrey Ptak

Morningstar, Inc.