Know what you own, redux

The ETF Industry

The ETF business, nee industry, is exactly that, a business.  As of April 2009 the Investment Company Institute calculated the nation’s exchange traded funds (or ETFs) had some $530 billion in assets under management.  As a point of comparison the nation’s open-end mutual funds held some $9.6 trillion in assets.  However the ETF business is growing far more rapidly than the traditional asset management business.

While the rest of the investment industry (open-end and closed-end funds) comes under consistent scrutiny, the ETF industry to-date has largely escaped a hard look.  However those times just might be changing.

One of the big stories of the week was the news that Blackrock Inc., the large asset manager reached a deal to purchase Barclays Global Investors the manager of the market leading iShares ETF business. The combined entity will now be the world’s largest asset manager as measured by assets under management.

With the recent news that Pimco recently launched an actively traded short term bond ETF, it should not be surprising that speculation abounds that Blackrock might push iShares into the actively managed ETF business.  The lure of the iShares business was strong enough to get the Vanguard Group to put in a bid for the business.  The news was an anathema to many Vanguard watchers who think the low-cost fund provider is above such crass motives of growth and profits.

For some additional background on the iShares deal we would recommend a couple of articles from IndexUniverse.com by Murray Coleman and Jim Wiandt.

However, leave it to Howard Lindzon to get at the heart of the matter.

The financial marketing is way ahead of the financial markets and light years ahead of the understaffed and undertalented SEC….

I was once a fan of ETF’s, but the top is long in on these financial marketing schemes sold on the basis of diversification and cost savings.

ETF’s will continue to work for those that create them and market them smartly as well as the few that know how to trade them. I don’t fit into any of these categories.

The bottom line is that the ETF providers are not your friends.  At their core they are asset gatherers and fund marketers.  Just because a new ETF is created does not automatically mean it is worthy of your hard-earned investment dollars.

Before we go any farther down the anti-ETF industry path, let’s pause and take note of some of the good things to come from the ETF revolution.  We have written previously how it amazing that investors can now create low-cost, globally diversified portfolios using ETFs.  In addition, investors can now access innovative investment strategies that were previously only available to institutional and high-net worth investors.  Indeed, any number of active investment strategies rely on ETFs for implementation.

Examples

That being said, the ETF industry has created products that have not lived up their billing.  We had earlier feared that some ETF investors would get trapped in what called ‘orphan ETFs‘.  While there has been a fair share of funds that have languished and have been liquidated, the bigger risk is in those funds that have become popular.

The first example are the 2x and 3x leveraged ETFs.  The most popular of which during the past year have been the Driexion Daily Financial Bull and Bear ETFs (FAS, FAZ).  These funds are designed to provide investors with leveraged returns (up and down) of an index of financial stocks.

The problem is that they don’t work as advertised.  A little thing called negative compounding has made the intent of the product moot.  Smarter people smarter than me have looked at this issue.  Specifically we would point you to the work of Adam Warner at the Daily Options Report, Matt Hougan at IndexUniverse and the guys at Bespoke Investment Group.  They have both documented how negative compounding has eroded the returns of both funds.  So much so, that the short interest in both funds has skyrocketed as traders have learned how to take advantage of this ETF design.

In the right hands (nimble traders) at over the right horizon (short) all of these leveraged vehicles can serve a purpose.  That number is surely smaller than the number of people currently using these funds.  The same could be true of our next example.

For whatever reason, the United States Natural Gas Fund (UNG) has become a favorite of traders and investors alike.  As an indication of its popularity, UNG is currently one of the most popular charts on Chart.ly.  You can see here the huge run up in volume in the ETF.

As one might expect at this point there is a problem.  The natural gas ETF is getting too big for its own good. FT Alphaville reports on the distortions to the natural gas futures market many speculate is caused by UNG.  This surge in interest is reminiscent of the situation that previously occurred wih the United States Oil Fund (USO).  In both cases the rise came despite the fact both markets were in contango.  (If you don’t know what contango is you have no business trading this instrument.)

Some even argue that there is an inherent flaw in the design of commodity funds that invest in futures contracts (and sometimes swaps).  Scott Burns at Morningstar thinks that funds like this are better described as “exchange-traded derivative funds.”  Burns goes on to suggest that investors should need approval, similar to options approval, to trade these vehicles.  Still on the topic of natural, gas Jason Goepfert at Sentiment’s Edge states things a bit more bluntly:

If you’re too lazy to read and understand what you’re trading, then you deserve to lose whatever money you “invest” in vehicles like these.

There could very well be a long opportunity in natural gas.  The ratio of the price of oil to natural gas is at (or near) a record high.   Historically this has heralded outperformance by natural gas versus oil.  The question is whether the natural gas ETF is the proper way to play this thesis.  We have discussed in the past the concept of ‘proxy investing.’  The crew over at StockTwits proposed a number of alternative ways to play natural gas prices.   Take note however that the natural gas thesis has already been well-publicized.

In this day and age there are any number of ways of expressing a market viewpoint.  Individual stocks, futures, options AND ETFs.  An ETF may be the proper vehicle, maybe not.  In short, you need to know what you own (and why).

Conclusion

It is hard to imagine an investment world without ETFs.  They have become a fixture for individual and institutional investors alike.  Few would argue that we are worse off for them.  However, the days of a handful of broadly diversified, plain vanilla ETFs is long gone.  As the number of ETFs that are leveraged, highly focused or derivative-based rises, maybe we need to take pause.  Proposals that call for enhanced disclosures and some qualification for individual investors might remove the riskiest funds from naive investors’ radar screens.

At a bare minimum, the investor needs to educate themselves on whatever ETF they are investing.  If you aren’t looking out for your interests, no one else will.  The information on these funds is out there.  You just need to look.  This education process will become more important as more ETFs embrace an active approach.

The news as of late points to a surge in interest in actively managed ETFs.  Investors should probably have that choice.  However, as we have learned with open-end mutual funds active management comes at a price:  higher expense ratios, higher turnover, tracking error and the risk of underperformance.

Most ETFs are harmless, if not downright useful.  However a number of ETFs out there do not perform as advertised.  If you are a sophisticated trader who understands the nuances of these products, then by all means feel free to trade them.  On the other hand if concepts like negative compounding, futures rolls and contango don’t come easily to you, step aside.  You should educate yourself before you put dollar one on the line.

*No positions in any of the securities listed above.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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  • Tadas ViskantaAbnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »

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