How To Safely Navigate ETF Waters (SPY, IAU, GLD, BRAQ, OIL, JYN, GBB, ERO, JJG, JJC, DBA, DBC, SH, DBB)

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November 11, 2010 2:04pm NYSE:BRAQ NYSE:DBA

David Fry: In 2003, I interviewed a successful sponsor and had the temerity to offer some suggestions where some ETFs were needed. The response from this person was: “Look, we’re not


 interested in filling needs as much as we are in building a business.” This made an important point: investors must align their investments to match their needs versus the business interests of sponsors.

The market for ETFs has never been more robust and expansionary. The most prominent activity for sponsors is similar to a game of Battleship where for sponsors the winner needs to fill all the slots before the next guy.

Why?  Because the “first mover advantage” to a sector and index cements their brand as “the go to shop”.

The most important activity for investors remains focusing on those ETFs that work and matter to them versus any sponsor’s marketing campaign.

It’s hard to imagine that in 2005 we published an essay “The ETF Tsunami” discussing the impending flood of new ETF issues about to hit the markets. Obviously it seemed even then the sector was undergoing explosive growth; but, with today’s level of issuance “tsunami” seems an understatement.

Then we noted issues amounted to roughly 200 but by 2010 there are nearly 1,000 with assets under management in the U.S. alone pushing one trillion dollars. Asset class coverage has also rapidly expanded from just a few stock and bond oriented funds to currency, commodity, actively managed, inverse, long/short strategies, options related, preferred, leveraged long or short issues and so forth. In short, there’s not an asset class that isn’t being traded or not in registration.

Further, internationally ETFs are also gaining acceptance and expanding rapidly. When visiting Australia as recently as 2004 there were few issues. Now there are hundreds of listings in just about every established market in Europe, Asia/Pacific and even Latin America.

There’s no getting around it, ETFs are here in a big way and here to stay.

This harkens back to 1980s when mutual funds were being issued almost hourly it seems. Being a financial consultant/broker in that period not a day passed without a mutual fund wholesaler wanting to share with you the latest and greatest fund.

I remember once being amazed to discover in the early 1980s that Fidelity had over 100 mutual funds. I wondered why they would have all those funds.  I looked at the roster and just shook my head and that’s before the growth in issues available just at Fidelity alone exploded to nearly one thousand. Each new mutual fund issue came prepackaged with its own marketing package and tools. Every day my snail mail was filled with this stuff. From the advisor’s viewpoint these products paid great fees and many paid every year. What could be wrong with this?

After the 2000 bear market began and mutual fund trading scandals dribbled out daily ETFs suddenly became the in thing. Wall Street’s new product engineers were reenergized by the rediscovery of ETFs which had languished in the backwaters of financial products for a long time. After all, here were products that weren’t tainted by everything that was plaguing the mutual fund industry.

I remember having lunch in 2004 with Nate Most who created the ETF product when working for the AMEX in 1990. He was shocked even back then how his baby was starting to take off. He recounted the story of the arguments he had with Vanguard’s pioneer Jack “you mean investors can trade them” Bogle.  Obviously, Bogle wasn’t a fan believing instead in the “buy and hold” strategy and (ahem) not to mention maintaining growing fee income to Vanguard. 

Nate, who sadly passed away the following year at the age of 90, only wished he could have earned a royalty on his creation.

We Can Do It Ourselves, Thank You!

Bogle’s little conflict of interest aside, the next thing was the emergence of an energized DIY (Do-it-Yourself) investor class. ETFs were products they could utilize away from financial advisors and their high-cost mutual funds. And, armed with these new tools and heavily discounted commissions.   

The loss of fee income for financial advisors was a serious set-back for mutual fund dependent financial advisors. As Donald Putnam, Managing Director, Grail Partners LLC put it: “ETFs are a very disruptive technology to the mutual fund world”.

The solution naturally for financial advisors was the wrap account. Clients were demanding ETF portfolios and putting them within the wrap account structure would allow for an annual fee perhaps even as high or higher than the kick-back from 12b-1 funds. Advisors could create all ETF portfolios created and approved within home offices, put their feet up and let Mr. Market take care of things for them.

But turning the Fee Titanic around was a slow and costly process since investors in widely placed 12b-1 funds had early redemption penalties to sort through.

Anyway, it isn’t any wonder that ETFs are growing at the expense of mutual funds. Further, demographics in the U.S. are changing making the “boomer” years of the 1980’s and 90’s not comparable. This makes domestic growth of funds less dynamic and indeed has altered demand to income oriented products.

Meanwhile Back Aboard the Ship

The number of players or sponsors in the ETF game is growing. Even brokers like Schwab are launching their own ETF products and Fidelity is in a partnership with Blackrock’s iShares. ETFs in registration with the SEC number in the many hundreds with long backlogs. ETF issues in the U.S. alone are pushing a thousand with assets under management soon to top one trillion.

Traditional mutual fund companies are challenged to enter the ETF market fearing cannibalization of existing products. Nevertheless, many can’t ignore the trend and have entered the business. Amvescap has purchased PowerShares and even Bogle’s old firm Vanguard features a large ETF product line.  

The way the battle works on the ETF seas is to be the first issuer to cover a sector before the other issuer.

Gold is a great example. State Street was the first out of the gate with SPDR Gold Trust (NYSE:GLD) in 2004. It now has over $50 billion in assets under management. Just a few months later in early 2005, iShares launched COMEX Gold Trust (NYSE:IAU) with assets under management of around $12 billion. Forgetting the structural differences this is the most prominent example of the Battleship game. IAU’s later launch doomed it to second fiddle status even though $12 billion in assets is nothing to sneeze at. To fight back and gain more market share iShares has cut the fee and declared a high stock (split 10:1) dividend.

The competition is good for buyers since it yields more favorable terms to them.

The scramble by issuers is still in high gear. With nearly an equal number of issues in registration with the SEC there is incredible business pressure to come to market first with similar offerings.

ETNs vs ETFs

ETP(Exchange Traded Products) include both ETFs and newer and more easily issued ETNs (Exchange Traded Notes).  Notes are popular given the easier registration and issuing process versus ETFs. Most ETNs are senior debt of the issuer/sponsor. Popular issues include commodity and currency issues from iPath (Barclays) and PowerShares (Deutsche Bank).

The risk to investors remains the credit worthiness of the guarantor. The reward is popular sectors become more quickly available.

ETP Products that Fail

In 2010 there are 250 ETPs with $20 million or less in assets under management. Some of this may be due to newness of the issue as assets are growing. On the other hand, investors should be wary of issues that may be in decline and in danger of being closed or merged with another fund.

Once again, this issue goes right back to the business interests of sponsors versus investors. As an investor you should monitor current AUM (Assets Under Management) of any ETP you’re considering as an investment or currently own.

There have been closures and mergers or the past few years with ETPs ranging from Northern Trust, Claymore Securities, Wisdom Tree, MacroShares and Grail Advisors to name a few.   

Protect Yourself at All Times

Individual investors are advised to always separate their investment interests from the business interests of issuers. Remember what an issuer CEO told me straight out: “We’re not interested in filling needs as much as building a business.” This must always be foremost in your thinking as you evaluate new or existing ETF issues.

What’s That Index Again?

ETFs are linked to indexes.

Most mature ETFs are linked to indexes we know fairly well: S&P 500, NASDAQ 100, Mid-Cap, Small-Cap, Treasury Bonds, and so forth. All these linked securities are widely traded, track their underlying index well and are trusted by the public.

In an effort to gain an edge perhaps as new entrants to the industry issuers are increasingly relying on new indexes, some created out of thin air while others employ so-called quantitative strategies. The latter generally can be found with PowerShares and a few other firms. These indexes generally utilize recognizable quasi-active methodologies which might take a conventional index reweight and rebalance them according to dividends, earnings momentum, book value, price to sales and so forth. Some of these work well, but you and/or your advisor should have a good understanding of the strategies used.

Another problem with some new indexes is obtaining historical data. Much of what you can get and analyze is comprised of back-testing what the index might have done had it existed previously. This methodology, dependent on how exotic the base, can be misleading since there’s no guarantee advertised results would have been realized.

Examples of new ETFs from Emerging Markets were just launched by GlobalX Shares. They feature little in the way of historical data for the index. This would include Brazil Consumer Sector ETF (NYSE:BRAQ) where historical data would be difficult to find since many of the companies in the index didn’t exist previously. Further, if they had existed, they would have been lightly traded or perhaps completely different structured companies. But, if like me you believe in the positive demographics of a young emerging Brazil consumer, then you’ll have to go with your fundamental beliefs.

Fees

You only need to remember one thing: the further away from the mainstream of major market indexes you wander, the higher the management fee for the ETF/ETN. Therefore, ETFs like the SPDR S&P 500 ETF (NYSE:SPY) will carry an annual very low fee of .10% to as high as 1% for more exotic sectors.

The higher fees are generally in more aggressive and/or exotic sectors. Alternative sectors like commodities and currencies generally have higher fees as do leveraged issues. If these sectors perform properly and your timing judgment is correct the rewards are much greater as are risks.

Buy and hold investors should logically concentrate on lower fees where possible.

 Actively Managed

An actively managed ETF is just a mutual fund masking as an ETF. After all, one of the beneficial characteristics of an ETF is it’s linkage to an index which is trackable and transparent. Issuers are still wrestling with effective ways to allow investors to track what managers are doing intraday. However, many managers don’t want others to see what they’re doing intraday for competitive reasons and perhaps other reasons like vanity and embarrassment.

If you know the fund manager and believe in what they’re doing, enter with your eyes wide open.

Commodity & Currency ETPs

Slowly and over time, currency and commodity ETFs have been launched. We’ve already featured (NYSE:GLD) but adding alternative investments to a portfolio does add to diversification thereby reducing risk.

Commodity tracking funds that include a wide variety of sectors (energy, metals, agricultural, softs and so forth) were launched first a few years ago by Deutsche Bank as ETNs (Exchange Traded Notes) which are guaranteed by Deutsche Bank Deutsche Bank as to integrity of assets in the fund. They have now partnered with Invesco PowerShares PowerShares for marketing purposes but still manage the funds in NYC. We’ve interviewed senior traders there many times.

They have a series of commodity ETNs including the Commodity Tracking ETN (NYSE:DBC); Base Metals ETN (NYSE:DBB); Agriculture ETN (NYSE:DBA) and so forth.

More recently, iPath iPath, a part of Barclays Bank with senior notes guaranteed, has joined in issuing ETNs on Copper (NYSE:JJC), Grains (NYSE:JJG), Currency (NYSE:ERO), (NYSE:GBB), and (NYSE:JYN), Energy (NYSE:OIL) and so forth.

Rydex Rydexwas first in issuing unleveraged currency issues for U.S. investors and we’ve been using them for quite some time.

Remember, with those issues deemed as “leveraged” most basic commodity and currency issues aren’t leveraged. When someone asserts dealing in these is risky I always respond: Given their structure they may not be risky enough so as to earn decent returns especially in currency issues.

Inverse ETFs

You’d think after experiencing two bear markets in one decade we’d want risk management tools to protect our portfolios.

ProShares ProSharesled the way in 2006 offering investors to short an unleveraged S&P 500 Index using the Inverse S&P 500 ETF (NYSE:SH). This was matched by other unleveraged issues during or shortly after this period on well known indexes like technology.

The primary purpose and benefit has allowed most investors to hedge their market exposure should stocks tumble. It is a more convenient way for individual investors to accomplish this without using options or futures.

Given its structure to achieve the inverse performance of the daily movement of the S&P 500 or any other index tracking can vary during periods of high volatility.

Investors should be aware of this and rebalance their exposure perhaps quarterly to adjust. Further tracking inefficiencies are perhaps no worse than options time deterioration given the complexities of incorporating those strategies.

There have been complaints about these and the leveraged issues given the lack of understanding as to how they work and who should use them. They’re not for everybody but then neither are bear markets.

Leveraged ETFs

I’m a fan of these products, and am glad ProShares, Direxion, Rydex and PowerShares (via Deutsche Bank) have made these available.   But like any other security or product, these issues need to be used properly.

When used correctly, they allow individual investors and advisors the opportunity to hedge and/or add more potential return to index-based securities.

An avalanche of complaints have been made recently by those taking the most egregious form of leveraged product use – buy and hold – to tar the entire levered ETF group negatively.

Sure, given the nature of how these products function, including within periods of high volatility and compounding issue complexity, they don’t achieve what some mistakenly believe is their job. But, this is not their proper use — period.

Leveraged issues should be used strategically and tactically by experienced investors over short periods of time, which may include day-trading and time periods of just a few weeks. To accomplish performance goals and achieve success, a disciplined and systematic approach is essential.

Commodity and currency markets have been difficult sectors for retail or financial advisors to participate in due to high entry costs for commodity pools and hedge funds, high ongoing fees and expenses, and even greater leverage than most investors are comfortable with. The introduction of ETF products in this area has given investors the opportunity to participate in markets previously unavailable to them. Trends in these market sectors can change quickly, and participating successfully in them therefore requires the careful application of trading methodologies. That’s what the most sophisticated investors in this sector do—they trade.

Have issuers done a great job of explaining this to the investing public? Probably not, but they’re working on it and so is the SEC, thanks to new education notices issued by Finra education notices issued by Finra.

Unleveraged inverse ETF products are a blessing to those investors wishing to avoid losing 40-50 percent of their portfolio’s asset value due to the occasional but devastating bear market, such as we’ve recently experienced. They don’t have the large tracking errors the whiners have ascribed to the entire product group.

Why shouldn’t retail investors and financial advisors be able to hedge or protect their own or their clients’ portfolios through the use of leveraged and inverse products?

Some have whined that they want the uptick rule reinstated to protect stocks and indexes from being attacked by short-sellers. This is a red herring, in my opinion. You can watch the tape on any trading day where sectors and stocks are being pummeled, and within even the shortest time frame, you’ll note plenty of upticks along the way down. 

And, speaking of smoke-screens and red herrings, now Edward Jones is prohibiting its clients and advisors from trading in leveraged ETF products.  It sounds paternalistic on the surface but masks the real agenda—they don’t want clients deviating from their high-fee plans sold to the masses door-to-door.

Many investors, retail and institutional alike, are day-trading leveraged ETFs. Whether they’re successful or not isn’t the issue. Many of these products are horning in on the action for options and futures traders. After all, options have caused more investor complaints and hardship than any ETF, leveraged or not. As a former options principal, I can say with authority that understanding options strategies is more complex and confusing than grasping the proper use of any ETF product.

Are there poorly constructed, bad or ineffective ETFs? Sure, and they’ll be winnowed out and disappear over time. But their number pales in comparison to the many worthless mutual funds still being issued and tormenting holders.

Those promoting individual stocks dislike the growing ETF market because most recent asset flows have been to ETFs and not single-stock issues. No wonder those guys are upset!

Leveraged and unleveraged inverse ETF products allow sophisticated retail investors and financial advisors the ability to construct hedge fund-like strategies for themselves and their clients that were heretofore unavailable for these investors. ETF products exist to protect investors from the carnage of bear markets and to provide opportunity to profit in bull markets.

And, of course, regulators with little else to do jump on the pile. State agencies are under pressure to justify their existence and defend their budget allocations in this era of poor municipal revenues.  State regulators can be the most uninformed pests amid the regulatory environment. 

Despite the few–but loud– naysayers, these products will continue to be used by thoughtful and disciplined investors to achieve portfolio protection and profit opportunity.

Creating ETF Portfolios & Hedge Fund-like Structures

Following are some typical strategies and portfolios the ETF Digest employs to help fill the needs of a variety of investor profiles.

It’s taken over 35 years of experience working with individual investors and financial advisors to find styles to suit their needs. The wide array of ETF products developed and made available over this last decade especially has made a huge difference. Now it’s possible to assemble a variety of portfolio structures previously unavailable.

Lazy Portfolio

If you’re an investor who doesn’t wish to do much trading then there exists many ETF opportunities to structure and assemble a diversified portfolio. These may include ETFs and ETNs in conventional equity sectors, international developed and emerging markets, domestic and international fixed income markets, alternative investments including currency and commodity sectors.

Portfolios may be structured to suit the needs of conservative, income oriented, balanced or more aggressive investors. Rebalancing may occur semiannually or as frequently as suits the investor. We generally rebalance semiannually but an annual rebalance is perfectly appropriate especially if taxes are a consideration.

Where possible products utilized should feature those with the most inexpensive management fee. Given that alternative markets (currency and commodity) generally have higher fees then investors have to accept that cost to be involved.

For financial advisors and planners using low cost ETFs enhances their ability to incorporate a wrap fee in a more cost effective manner acceptable to clients while still earning a good livelihood.

Lazy Hedged Portfolio

Given that we’ve already experienced two bear markets in this decade many investors and advisors are looking more closely at a variety of risk management strategies to prevent portfolio destruction. Basic math indicates if your portfolio loses 50% of its net asset value, you’ll need to make roughly 100% just to get back to even. This is a very large hole to dig yourself out of and generally takes a lot of time. When will the NASDAQ be 5,000 again as an extreme example?

There are suitable ETF strategies that can be incorporated with an overall lazy approach. There are unleveraged inverse ETF issues that can be blended with almost any strategy. Conventional hedging strategies usually employed the use of options. As a former options principal, it’s easy for me to say these can be complex, expensive and ineffective.

Unleveraged inverse ETFs are by no means perfect especially when tracking issues become more inefficient due to high volatility and compounding problems. To help cure this potential deficiency we rebalance our hedged portfolios quarterly. Even then the hedge won’t be perfect since we might only have 25% of the portfolio devoted that way.  It will only provide a smoother ride.

Financial advisors and planners can provide their clients with some risk management strategies that don’t require heavy trading just some quarterly rebalancing.

Hedged portfolios are structured in the same manner as those that are unhedged. The only addition is the applicable inverse issue. Adding this will limit performance in bull market conditions but also limit losses when bear markets exist.  

Moderately Traded Portfolio

At the ETF Digest we maintain three actively managed model portfolios. Two approach markets from a technical view but are arranged based on fundamental views of sector exposure. Technically these portfolios utilize weekly charts which would, when successful, feature trading from an intermediate few thus eliminating frenetic activity. When not successful we’re stopped-out which could be abrupt.

Portfolios are arranged similar to a hedge fund structure akin to Global Macro Long/Short. Portfolio constituents are fixed but may change annually to keep up with fundamental global economic views and new ETF issues more suitable to the goals.

Unleveraged inverse ETF issues may be utilized as speculative investments over an intermediate term when appropriate. If warranted these may be paired with long positions in other ETF sectors.

Occasionally, when trading ranges are dominant, we don’t hesitate in maintaining high cash balances which can last an indeterminate period. Sometimes it’s best to sit things out until trends become clearer.

Again having the expanse and variety of ETF issues makes this type of activity possible where it wasn’t just a decade ago.

Actively & Aggressive Portfolio

One last portfolio in our arsenal is opportunistic from an open menu of ETFs, utilizes leveraged ETF issues and maintains an open menu. Trading can be frenetic and certainly isn’t for everyone given the higher risks anticipated.

Given all the bad news that dogged leveraged issues in 2009 it’s important remember how to use these issues properly. For us, this means they must be traded and held over a period of a few days to a couple of weeks at most.

When opportunistic, we’re hoping to find ETF sectors moving in an uncorrelated fashion with overall market trends.

Utilizing leveraged issues can when correct enhance performance if only used over short periods. When the strategy is not successful losses may be substantially higher than most investors would want exposure to.

In sum, trading is active and frenetic, risks are high and taxes may negatively affect overall performance given short-term results.  When these strategies are successful performance can be substantially increased—or, the more the risk the higher the potential results and losses.

CONCLUSION

We’re most happy with the tsunami of ETFs on or about to enter markets since among the tailings we’ll find nuggets to suit all the previously described strategies.

With the onslaught of new issues and many issuers anxious to enter the sector there will be failures. Poorly conceived, marketed or supported ETFs have folded and/or merged with other existing products. Some strategies just don’t work and we’ve seen failure with some commodity ETFs where the issuer wasn’t capable of dealing with the unique aspects or quirks related to markets like “contango and backwardation”. Failures will continue.

There is no such thing as a win-win condition for any strategy or combination of ETFs within any portfolio.

The good news is the heavy issuance of ETFs creates opportunities for investors that heretofore never existed. The bad news is investors will have to work harder to separate the wheat (issuer’s interests) from the chaff (investor’s interest).

Published in the October 2010 AAII Journal.  David Fry is founder and publisher of ETF Digest [www.etfdigest.com] and author of Create Your Own ETF Hedge Fund, A DIY Strategy for Private Wealth Management (Wiley Finance, 2008).

Written By David Fry From ETF Digest

David Fry writes a subscription newsletter focused on technical analysis of exchange-traded funds, called ETF Digest (http://etfdigest.com/). Dave founded the ETF Digest in 2001 and was among the very first to see the need for a publication that provided individual investors with information and advice on ETF investing. We particularly like the overview of financial markets that his work provides. Even if you’re not a fan of chart analysis, Dave provides insight and commentary into which global markets are “working” and why.  David is the author of Create Your Own ETF Hedge Fund: A Do-It-Yourself ETF Strategy for Private Wealth Management.


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