Working with Exchange Traded Funds (ETFs)

How Are ETFs Created? Unleveraged stock ETFs are typically formed by an institutional investor. They often create an ETF by borrowing large blocks of stock (25,000 to 200,000 stokes41) from a pension fund. The block of assets in this ‘creation unit’ are in the exact ratio of the index they want to duplicate. The ETF trust then issues stokes which have legal claim on the stokes in the trust.

When mergers or acquisitions happen with companies in the index, funds need to rebalance. If some assets overperform or underperform in the ETF, they are sold or bought to keep the fund in the same ratio as the index it follows. Managed ETFs might rebalance quarterly. Traditional ETF may rebalance once or twice a year.

Tax Advantages: ETFs have more tax advantages than open-ended mutual funds. When a trader sells their stokes of mutual funds, the underlying stocks are sold and the cash given to the owner. This can create capital gains for every holder of that mutual fund. With ETFs, the buying or selling of the share does not change the ownership of the underlying assets.

ETFs usually sell for close to the total value of the index they follow. If you add up the per share value of the stock of each company in the fund, the fund’s price should be very close to that number. If it rises (premium) or falls (undervalued) by more than a small amount, institutional investors step in. They take advantage of that small difference. Their arbitrage buying or selling brings the price back into line.

Lower Costs: ETFs most often have lower associated costs than the same kind of mutual fund. In addition to the tax savings mentioned above, you save on:

• Management fees. They have no research costs and are un-managed
• Commission costs. Fewer stokes are traded
• Entry costs. You can buy just one share instead of a minimum order for mutual funds.

Fully invested. ETFs can put all their money to work. They don’t need to hold out a reserve to pay for redeemed stokes

10.1 Kinds of ETFs

Bond: Investors can buy a wide range of bond funds. They may choose funds based on bond length: short, intermediate or long. Other bond ETFs invest in bonds of different nations, from China and Australia, to California Muni and international corporate bonds. You can find bonds based on money markets, maturity dates, and mortgage backed. For investors who want to diversify into any broader market, there’s an EFT for that.

Currency: Currency ETFs give investors an easy way to enter the currency market. They can choose an ETF that holds futures contracts for a specific currency or ETFs that invest directly into a currency, or a group of currencies. Both have the goal of matching the performance of a certain foreign currency, rather than beating performance. If you think a currency will rise or fall, an ETF can be a simple way to try to take advantage of the move.

Commodity: Commodity ETFs give investors exposure to agricultural products, energy resources and precious metals. An investment in copper, crude oil, or gas is different from investing in a company that produces or manages it. Unlike equity ETFs, commodity ETFs seldom own the underlying asset, with the exception of gold and silver. Some funds actually own the precious metals stored in vaults.

More typically the ETFs buy futures contracts for oil, soybeans, or whatever commodity or index it follows. Futures lose premium value as they get closer to their expiration date. This premium loss can add up over time, making these ETFs best for short term investing. If you want to hold oil or other commodities long term, you may be better off with an equity ETF.

Equity: Many investors use ETFs to diversify into different asset sectors ranging from energy, to financial, healthcare, or industrials. Check your investment strategy and find ETFs that give you exposure to different sectors. It pays to review the stocks in the index your ETF follows to avoid duplication. Some ETFs invest based on size, such as small, mid, or large cap, or they may focus on value investing or new technology.

Region: Choose ETFs that are located where you think markets might outperform: Europe, China, India, or perhaps the Middle East. You can invest in country-specific ETFs or in a basket from developing countries or emerging markets. Worldwide diversification helps broaden your portfolio to different trends. ETFs make it easier to hold equities from foreign countries, especially if the stock is not traded on your country’s exchange.

Real Estate: You can gain easy access to real estate exposure with real estate ETFs. With this method, there’s no need to worry about a down payment or mortgage payments. Many Real Estate ETFs seek to mimic the performance of certain indices. Most ETFs do this by buying REITs (Real Estate Investment Trusts).

These companies either own physical properties or they hold mortgages to properties. The properties within an ETF may be held based on location, business, or size. Some might focus on hospitals, other on malls in New York, or apartments in London. They may also be companies that manage properties. Real Estate ETFs can look for high returns, potential growth, or acquisitions. Remember that all investment carries risks and there are no guarantees.

Volatility: These ETFs try to mimic the volatility of the Volatility Index (VIX) or other volatility measurements. Since they often move inversely to the major market indicators, they can be attractive for day trading. For example, if the markets rise, volatility often falls. Most of these ETFs are based on exchange traded notes which have no assets behind them. These ETFs do an imperfect job of following their indices and can involve a lot of risk. Because of premium decay on futures, these funds are not recommended for long term holding.

Actively Managed: These ETFs have portfolio managers who more actively balance the ETF by buying and selling. This is in an attempt to achieve a specific objective. In this case, they seek to beat the market or the index. While they still take advantage of the ETF benefits, management fees rise a little. ETFs began because the indices often beat managed funds. It’s possible the managed ETFs can cost more and produce poorer results.

With hundreds of ETFs to choose from, you can find ones that fit your risk level, your portfolio, and your diversification strategy. You can check out different ETFs at the Equities Reserves ETF page. Remember, all trading involves risk. Only risk capital you’re prepared to lose and of course, past performance does not guarantee future results.

10.2 Leveraging ETFs

While traditional ETFs seek to mimic the indices they follow, inverse ETFs want to do the opposite of the index. If the index goes down, the ETF should rise by the same amount. And leveraged ETF want to do it times two or three. These funds use leverages and hedges to accomplish their goals. Their design and makeup are different from simple stock ETFs.

Inverse ETFs: An inverse ETF is designed to give you profits when the underlying asset drops. Investors may use this as a hedging tool against market corrections. For example, if the FTSE goes down £10, the inverse FTSE fund such as XUKS would hopefully rise by £10. Double (SUK2) or triple inverse (UK3S) ETFs hope to multiply the drop by returning you £20 or £30 for each £10 drop.

These funds are sometimes called ‘short’ or bear ETFs. They do not hold the FTSE or underlying assets. Rather they use transferable securities, derivatives, and swap agreements. It takes active management on a daily basis, so the fees for these ETFs are much higher. Often they are 1% or more. The funds rebalance their assets on a daily basis to keep the inverse with that day’s move of the index.

This daily rebalancing means that each day’s move is a separate event. It can lead to an extra percentage, or more in a fall over a few days. However, the ETF will lag in the rebounds giving you poorer performance. It’s a highly sophisticated tool often best used very short term or left to professionals. There are other ways to short a market. Statistically, if held long term, they disappointingly underperform.

Leveraged ETFs: A leveraged ETF is designed to give you two or three times the return of the underlying asset. These ETFs may be called Ultra 2x, or double long. The funds work by both holding some of the asset and through swap contracts. These create a ‘notional exposure’ that is two or three times the daily return of the index or asset. At the end of each day the fund must rebalance to maintain that notional exposure.

This leverage can work both for ETFs seeking to track the market and those wanting to short the market. The promise of double or triple returns may work for a day or in a very strong up or down movement over a few days. But the longer it is held, the less likely you are to get the results you want.

For example, here are two funds that track the MSCI Emerging Market Index:

• Short MSCI Emerging Markets ProStocks (EUM)
• UltraShort MSCI Emerging Markets ProStocks (EEV)

They are designed to go up if the index goes down. Yet in 2008, when the index lost 52%, the short EUM gained only 20%. Meanwhile, the UltraShort not only didn’t go up 100%, but it also lost 25%! This is not unusual. Rather, it’s typical for leveraged ETFs.

Part of the problem is that the funds are designed for one day use, and this is an annual return. The reason they fail is that the returns are compounded daily on market fluctuations. The chart in Chapter 2 reminds us how much assets must gain after a loss to come back to even. A 30% loss needs a gain of 43% to recoup the loss. When the underlying asset returns to break-even over a period of days, the ETF can’t make up the difference.

Paul Justice, writing for Morningstar says:

With virtually every leveraged and inverse fund, I can tell you that they are appropriate only for less than 1% of the investing community. Considering that these funds have attracted billions of dollars over the past year alone, it’s pretty obvious that too many people are using these incorrectly.

…[W]henever you hold these ETFs longer than their indicated compounding period (typically one day for stock-based ETFs, sometimes monthly for commodities), you are almost mathematically guaranteed to get a return that is not double that of the index. In fact, the longer you hold one of these funds, the probability that you will get nothing close to double the returns increases.

10.3 Trading ETFs

A simple way to take advantage of ETFs is to buy and sell them on the stock market. One benefit to this method is that you can use leverage and short selling ETFs in retirement accounts that might prohibit short selling in other ways. And buying leveraged ETFs only exposes you to the potential loss of your investment. This is different from options or leveraged CFDs that can create a loss far greater than your investment.

However, CFDs offer an alternative way to trade ETFs. These Contract for Differences allow you to trade based on the price change of the index or ETFs. Since you can arrange a contract at a fixed price, it’s easy to short the indices or ETFs. With CFDs you also have access to many funds that are normally outside the reach of your local securities exchange.

The low-cost, transparent nature of ETFs make them a vehicle of choice for diversification. They have an inexpensive entry point and it’s easy to see the kinds of assets you are buying. However, when you move into leveraged and inverse ETFs you gain more risk. The rewards and risks are multiplied. While the leveraged ETFs clearly tell traders they are rebalanced daily, few investors understand this kind of leverage is unlikely to work over the long run.

Consider ETFs as just one aspect of a balanced, risk-adjusted portfolio.