Simple Is Best With ETF’s

complicatedIt was bound to happen, I suppose. While exchange-traded funds have not yet attracted the multi-trillions of dollars that mutual funds have, ETFs have become popular enough they’re starting to acquire some of the bad habits of their older rivals.

The first generation of ETFs were low-cost, broadly diversified products from firms like Barclays and Vanguard, well suited to average investors wishing to expose the core of their portfolios to the broad equity market.

But we are well into the second phase of ETF proliferation, with more volatile sector ETFs sporting considerably higher price tags. How complex it’s become can be inferred from the fact BetaPro Management Inc. is hosting an all-day Horizons ETF University session today at Ryerson University, part of a seven-city road show. 

BetaPro came under fire last week from consumer advocacy group FAIR for not disclosing clearly enough the risks of the firm’s leveraged bull and bear ETFs. The (Canadian) Foundation for Advancement of Investor Rights was founded last year by Ermanno Pascutto, formerly of the Ontario Securities Commission. Its report, entitled Heads You Lose, Tails You Lose: The Strange Case of Levered ETFs, seemed to validate what forensic accountant Al Rosen wrote in this newspaper late in 2008: that such ETFs are more appropriate for sophisticated day traders than buy-and-hold investors.

Betapro president Howard Atkinson insists his levered ETFs do just what the firm’s marketing materials say they do: they’re “designed to offer double the daily performance of their underlying index or benchmark.” As he said on TV, depending on the path the market takes, the ultimate return may be better or worse than two times. Because volatility is magnified by double leverage, investors need to rebalance often, he said. There is a prominent warning of the risks on the front cover of each prospectus.

No doubt it’s the word “daily” that trips up investors. FAIR offered examples that revealed after 12 months, even investors who came up with a correct investment thesis and acted to profit on it via these ETFs often lost money.

Canadians bought more than $2-billion worth of these ETFs on the assumption they’d help them make them money if they correctly guessed the short-term direction of particular sectors of the market. They are among the most actively traded stocks on the TSX, although similar products are also on American exchanges: Rydex Investments, ProShares and Direxion Funds.

In January, Morningstar Inc. warned leveraged ETFs can “kill” a portfolio. Morningstar’s Paul Justice warned “you might not even get returns that are in the same direction as the changes in the indexes.”

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