Monday, April 27, 2009

The ETF Temptation

The new next best thing is not as new as you might think. In the long-term picture, the birth of the leveraged ETF is a mere infant among other ETFs and in terms of investment interest, a mere mote in the eye of mutual funds. But the fact that they exist; the fact that they seem alluring; the fact that they promise, at least on the surface a double, sometimes triple return on the index they follow, makes them worthy of our concern.

Exchange Traded Funds have been around for years, offering investors a short-term opportunity to play a specific index without exposing the investor to many of the individual companies within. Meant to be something short-term, the costs are mostly assumed by the investor with each trade in and out. Because the ETF is indexed, the costs remain low.

But leveraged ETFs are something entirely different. In many instances, leverage is done on margin, borrowing shares and paying interest on the loan. In a leveraged ETF, the leverage comes from derivatives like index options, index futures and equity swaps. The fund promises to double the return by exposing the investor to the possibility that the should the index go up, the underlying fund, because it has twice (and sometimes triple) the exposure to that particular index, will go up twice as much. A one percent gain in an index will give the investor a two percent gain.

On the flip side, a one percent loss will also expose the investor to twice the downside return. This has created a last hour of trading concern as these funds attempt to make their leveraged position do what it was intended to do. But what many investors do not realize is the volatility these funds create - rapid rebalancing to keep the fund exposed has super-charged that last hour of trading.

The risk here is referred to as counter party risk. In short, counter party risk in mutual funds and ETFs is as follows: In a mutual fund, the manager may buy a security that is a repurchase agreement whereby a seller agrees to a price for security and the commitment that they will repurchase that security at set price and time. The risk here is you are never quite sure what kind of commitment the other party has with other investors. This creates the illusion that, should the other party default, the investors standing in line will be you alone.

There are several things you should be aware of in these funds. According to NobelTrading, "The daily rebalancing of leverage results in extra trading, interest and management costs, which can eat up the profit. This make leveraged ETFs unsuitable for long-term profiting."

If these types of funds are showing up in your retirement plan (offered in your 401(k)) it is important that you understand the potential risk. Some have suggested that this is the new threat to the markets as banks and trading firms distribute last hour last minute news items that force the markets in one direction or another. For the individual investor, these often sharp moves can be incredibly frustrating. A single days gains can be wiped out in a matter of minutes and for no apparent reason. This makes for a very uneven playing field, tipping the advantage in the wrong direction.

Now it should be noted that some mutual funds use this technique as well. And although they do, the differences are magnified in ETFs because of the rebalancing done throughout the day. Unlike buying on margin (which has limits to the amount of shares that can be bought at 25-50% and charging interest for the service) the type of purchase ETFs often use is called an option.

Simply put, an option allows the investor, in this instance the fund manager to buy a security at a set price (option is an instrument that allows you to lock in a price for shares of a particular company which gives the investor the "option" of actually buying those shares at that price at some future date). If the price of the underlying stock increases, then the fund manager will have a much lower price paid for the option than the stock is now worth and it was done with money they did not already have. This creates an outsized profit that would have been unrealized had the fund manager simply kept the shares in the portfolio.

In ETFs, these options are often of the short-term variety. And while this type of transaction can magnify profits, the losses also suffer a doubling (or tripling) effect. Should those options expire while the share prices is low, they essentially become worthless. Add to that, the index you are invested with may have created a taxable event, a higher than index averaged trading costs and fees, and headaches for the rest of us.

To add to the confusion, the leveraged ETF makes little sense to those who ascribe to the old adage: sell high, buy low. The daily rebalancing will often find the funds that hold them buying into a rising market and selling assets as the market declines. And this is not the kind of rebalancing the average investor can wrap themselves around.


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