How not to get burned by ETFs

Exchange Traded Funds, or ETFs, are a well-received innovation for online trading that hit Wall Street after the creation of mutual funds. 

Image courtesy Images of Money: http://www.flickr.com/photos/59937401@N07/ETF trading has basically become an instant success overnight, allowing retail traders to buy futures, commodities, whole sectors, industries and even foreign markets as if they were stocks. The ETF has empowered retail traders/investors to take control and be exposed to risk in areas that they have not had access to in the recent past.

ETFs trade more similarly to stocks than mutual funds with fast execution and good liquidity, but with lower fees and in some cases, the diversification that mutual funds can offer.

Many traders misunderstand ETFs and lump them in the same category as mutual funds. This couldn’t be further from the truth. ETFs are not mutual funds and do not act like mutual funds.

When an investor purchases shares of a traditional mutual fund they do so by buying them through the mutual fund. In other words, the investor gives their money to the mutual fund, and a fund manager actively buys actual assets. 

For example if I wanted to invest $1,000 in XYZ dividend mutual fund, I effectively send my money to the fund manager, and the fund manager purchases the dividend stocks bases on the fund’s policies.

The key takeaway here is the purchasing of the actual stocks directly. The same is true when cashing out of the fund; the fund manager will see your actual assets and then send you the proceeds. Some funds will pay out in the actual assets. This allows for what is known as 100% reserved. The mutual fund securities it owns correspond 100% to the shares its investors own, a one to one relationship.

ETF shares are traded in the open market in which a retail investor buys and sells them either via their online broker or through a traditional full service broker. The ETF manager issues and redeems shares daily, similar to a mutual fund, except the mutual fund only issues and redeems shares through institutions, market makers, and brokers.

As the ETF landscape has grown, especially in the last few years, ETF products have been created in areas that really should be left to professional or advanced traders. One of the most dangerous types of ETFs retail investors can be burned on are leveraged ETFs. 

The seduction is overwhelming. Who would not want be involved in an ETF that supposedly has twice the return of an index averaging 5% – double is better right?  Why settle for 5% in XYZ index when ETF ABC provides twice the return of XYZ index? 

The fundamental problem with any leveraged ETF is similar to the problem with an option: value decays over time. The decay is caused by the daily reset ETFs need to perform. For example in leveraged ETFs that track a given index, the underlying index will oscillate, or move higher and lower throughout the trading session, and over time the leveraged return slowly declines. 

If you hold a leveraged ETF for weeks or months, you’ll find many ETFs actually become negative when compared to the actual performance of the index they were meant to track. If you’re lucky you’ll be in the green, but nowhere near x factor.

Another problem with many leveraged ETFs is that they track indexes that large institutions, hedge funds, and day/swing traders pile into at the open of the market; and based on the futures and sentiment push the ETF around on the basics (short/long), and exit at the end of the day – leaving the little guy holding the bag. These types of ETFs should be used for short term trades; intra-day to no more than a week. 

A great example of this is when we compare the daily move of the Pro-Shares Ultra Short S&P 500 ETF (SDS, quote) over May 2012. The S&P 500 moved nearly 10%, while the twice leveraged SDS ETF that theoretically should have returned nearly 20%, only returned 12%. 

Did you make money? Yes, but no where near twice the move, and the only reason SDS was in the green by so much was the length and amount the S&P fell. 

This theory holds true for any leveraged ETF, whether its tracks assets domestically, internationally, commodities or emerging markets. The key word is leverage.

Until our next installment of ‘How not to get burned with ETFs’, I want to leave you with a tip for trading ETFs in general. As mentioned, ETFs reset at least once a day, making it difficult to know if an ETF is overvalued or undervalued. To find this out, check the ETF’s net asset value (NAV), which represents the actual value of the ETF holdings. If your online broker does not supply this data it can be found on the fund’s website.

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