Exchange-Traded Funds are arguably great tools for every day
investors seeking to implement a variety of strategies in their
portfolios. These funds allow investors to tap into strategies that
were once reserved for professionals—like leverage and commodity
investing—and they also permit so-called ‘lazy’ investors to build
a portfolio cheaply and quickly, with minimal maintenance.
This has become even easier over the past few years as more and
more funds have hit the market, bring the total number of ETFs well
over the 1,000 mark and combined assets in the space over the key
$1 trillion level. Yet, despite the proliferation of ETFs over the
past few years, several misconceptions remain about the product
type and how they not only work, but are designed to be used as
well.
This is rather unfortunate as there is a great deal of education
out there about the ETF market and how these new funds are built
for investors. However, instead of learning more about the funds,
many just blame the product, declaring these new funds somehow
‘flawed’, despite plenty of evidence to the contrary.
From what I have seen over the last few years, most ETF
complaints and confusion center around a few key issues that are,
time and time again, at the heart of investor misunderstandings in
the exchange-traded fund market. Fortunately, all three of these
ETF mistakes are easily explainable, and rectifiable, with just a
few extra minutes of research and education (read ETFs vs. Mutual
Funds).
Below, we highlight three of the biggest mistakes
investors make when investing with ETFs. Hopefully, this discussion
will assist investors in better understanding how ETFs are designed
to be used, and some of the main pitfalls that often slip investors
up when they are looking at this relatively new product type:
1. Not knowing how Leveraged ETFs work
Despite many investors holding leverage ETFs over long time
frames, most of these funds were designed to be held for a single
day, and nothing more. That is because most of these products
rebalance at the end of every session and are built to only give
investors the corresponding amount of leverage over a single
trading period.
The importance of this cannot be stressed enough, especially
during oscillating markets with volatile funds. During this
situation, an underlying index could move wildly, finish back at
breakeven but the overall fund, thanks to leverage and rebalancing,
could deviate significantly from this amount. Take for example this
chart from Direxion:
As you can see, the index value is unchanged, but the cumulative
fund return is negative, how can this be? Well, the daily
rebalancing pretty much makes long term returns incomparable in the
same way that a daily compounding bank account will not match one
that never compounds; they are just two different ways of attacking
the problem.
However, it should be noted that when markets are moving in a
single direction—either up or down—the impact of compounding can
actually work in your favor, leading to better-than-expected
returns. Unfortunately, long-trending markets are relatively rare,
especially when you are using 3x leverage in a fast moving
sector.
Investors should also realize that most funds are structured
like this, although not all are. There are a handful of monthly
rebalancing ETFs that seek to only readjust once a month and thus
can cut down on some of the issues that daily rebalancing funds
face.
iPath has also recently debuted a series of non-rebalancing
leveraged products, but these have their own problems as well.
These ETNs do not stay at a stable leverage level, meaning that the
rate of leverage is variable and can change from not only month to
month but day to day as well. Thanks to this, the leverage can dip
below or above what it was initially purchased at, meaning that
investors may not always know—just by looking at the fund—what the
true leverage rate is.
While this might be too technical for many, the moral of the
story is; don’t use leverage products unless you understand them!
The rebalancing can eat away at returns over long time periods so
if you are dead-set on using these potent products, make sure to
monitor them closely or only use them for short-time periods (for
more on this subject read Understanding Leveraged ETFs).
2. Not understanding the futures curve’s impact on
commodity products
The expansion of the ETF world into the commodity market has
given investors a host of new ways to target natural resources.
However, this has exposed new investors to a problem that they have
never faced before; contango.
Contango is when the forward price of a futures contract is
greater than the expected future spot price of a given commodity.
As the contract date approaches, a commodity in contango will see
its price fall in order to come closer to the spot price (Read Buy
American with these Three Commodity ETFs).
Since many commodity ETFs use futures and cycle into the next
contract month on a regular basis, they often face the worst of
contango. In other words, many ETFs in the commodity world that use
futures contracts ‘buy high and sell low’, a factor that often eats
into long term returns in deeply contangoed markets.
A great example of this is in the VIX S&P 500 Volatility
Index. While not a true ‘commodity’, this benchmark usually suffers
from contango, and it has also had a terrible performance so far in
2012, losing about 36% YTD, at time of writing. Yet, the main ETN
tracking the VIX, iPath’s VXX, has lost over 72%
in comparison, as contango has ripped into any returns that VXX may
have wished to accumulate in the time period.
However, it is worth pointing out that when a commodity is in
the opposite environment, backwardation, investors can profit. In
this situation, the ETF is constantly selling contracts close to
the spot and buying ones further out on the curve for less.
In this type of situation it is relatively easy to make money,
although most times commodities are not in this state. The entire
problem can be avoided by looking at products that physically hold
the commodity but these are relegated to the precious metal market,
at least for now.
Another way to avoid the problem is to try and look for
‘contango fighting’ ETFs that seek to spread assets across the
futures curve instead of continually buying the next month out.
Products form Teucrium, United States Commodity Funds, and iPath’s
Pure Beta series all do a solid job of this, although the problem
of contango can never be completely eradicated (see Is USCI The
Best Commodity ETF?).
3. Forgetting to delve into a fund’s
holdings
ETFs are pretty transparent products, and are certainly more so
than their mutual fund cousins. ETFs offer up daily disclosure
requirements which are light years ahead of mutual funds which are
only required to update investors once a quarter on holdings.
Still, ETFs aren’t immune from stretching the boundaries a little
when it comes to product names.
By this I mean ETFs can sometimes suggest one focus from their
title but have a much different target when one looks at the
underlying holdings. In other words, investors often assume that
when a few ETFs have similar names they have pretty much identical
holdings, this is usually not the case.
For example, the iShares Dow Jones US Home Construction
ETF (ITB) and the SPDR S&P Homebuilders ETF
(XHB) sound pretty similar, right? However, the products
couldn’t be more different as ITB has roughly two-thirds of its
portfolio in the home construction industry compared to just under
30% for XHB (read Top Zacks Ranked Construction ETF- ITB).
The trend is by no means limited to homebuilders, as the
Gold Miners ETF (GDX) has, according to
research from Global X for their Pure Gold Miners ETF
(GGGG), its fourth biggest holding in Silver Wheaton, and
four companies in the top ten that derive less than two-thirds of
their revenue from the yellow metal. Despite this, GDX is by far
the most popular gold mining ETF on the market today, thoroughly
crushing the competition.
One last example of this is in the case, although there are many
others, is in the regional banking ETF (RKH). Some
of the ‘regional’ banks in the fund’s top five holdings include JP
Morgan, Bank of America, and Citigroup. Unless regional means ‘the
entire world’ this doesn’t really make much sense.
So ETF disclosures about positions are there for a reason, use
them. While I wouldn’t say any of the fund companies highlighted
above are lying or misleading about their holdings, many investors
might not be getting what they are expecting if they just buy an
ETF based on the fund name, making this easily one of the biggest
mistakes that is made when investing with ETFs.
Want the latest recommendations from Zacks Investment
Research? Today, you can download 7 Best Stocks for the Next 30
Days. Click to get this free report >>
Follow @Eric Dutram on Twitter
MKT VEC-GOLD MI (GDX): ETF Research Reports
GLBL-X PGM (GGGG): ETF Research Reports
ISHARS-DJ HO CO (ITB): ETF Research Reports
MKT VEC-BANK&BR (RKH): ETF Research Reports
IPATH-SP5 VX ST (VXX): ETF Research Reports
SPDR-SP HOMEBLD (XHB): ETF Research Reports
To read this article on Zacks.com click here.
Zacks Investment Research
Grafico Azioni Global X Pure Gold Miners Etf (AMEX:GGGG)
Storico
Da Mag 2024 a Giu 2024
Grafico Azioni Global X Pure Gold Miners Etf (AMEX:GGGG)
Storico
Da Giu 2023 a Giu 2024