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InvestmentPulse

Are exchange-traded funds dangerous? (Part 3 of 4)

March 13, 2012

In the last two editions of the Pulse, we addressed important criticisms of physical and synthetic exchange-traded funds (ETFs), which make up the bulk of the ETF market. In this issue, we will discuss exotic ETFs. More specifically, we will look into three types of exotic ETFs: leveraged, inverse and commodity ETFs.

What are exotic ETFs?

We define exotic ETFs as those that are not based on simple stock or bond indices. Gaining a reasonable understanding of exotic ETFs requires a very high level of knowledge about the capital market, and in most instances, a deep understanding of derivative products. Financial institutions are continuously inventing new products, so there is a wide (and growing) variety of exotic ETFs. Let’s look at three of them.

Three types of exotic ETFs

Leveraged ETFs are structured to provide investors with up to three times the daily return of an underlying asset. These securities comprise a combination of short-term fixed-income securities and a buyer position in futures contracts. They therefore provide an amplified (positive or negative) return on a stock index, a commodity, a currency, or anything that exists on the futures market. For example, if an investor holds a two-times leveraged ETF on a given index, and that index rises 4% during the day, then the investor makes an 8% profit. Conversely, if the market declines 4%, the investor loses 8%.

Inverse ETFs are structured to provide investors with between one and three times the inverse of the daily return of an underlying asset. These securities hold a combination of short-term fixed-income securities and a seller position in futures contracts. They can therefore provide an amplified (positive or negative) reverse return on anything that exists on the futures market. For example, if an investor holds a two-times inverse ETF on a given index and the index rises 4% during the day, then the investor loses 8%; conversely, if the market declines 4%, the investor makes an 8% profit.

The vast majority of commodity ETFs comprises a combination of short-term fixed-income securities and a long position in commodity futures contracts. In rare cases, commodity ETFs will contain a physical commodity if it is easy to store, such as gold or silver. In some cases, commodity ETFs can also be leveraged or inverse.

Are exotic ETFs dangerous?

Leveraged, inverse and commodity ETFs are just a few of the many exotic ETFs in existence. We believe most exotic ETFs are potentially dangerous to investors because they share two important characteristics.

First, their complexity goes far beyond the financial knowledge of most amateur and professional investors. Although exotic ETFs are quite simple in the eyes of derivative-product experts, they baffle non-experts.

Second, these ETFs sometimes behave very differently from what would reasonably be expected. For example, between January 1, 2008, and the end of January 2012, the MSCI Emerging Markets Index returned a cumulative -9.6% including dividends. Logically, one would expect that an inverse ETF based on the very same index would deliver a positive return over the same period. Surprisingly, however, the (US-listed) Proshares UltraShort Emerging Markets ETF, which holds a two-times inverse position on the index returned…-92.1%! And this is not the result of fraud. The ETF is designed to deliver two times the daily inverse return of the index, but if you hold it longer than a day, then the relationship between the index and the ETF is unpredictable.

Our advice

Those of us who care about our money should leave exotic ETFs to speculators. Most of these ETFs are too complex and too unpredictable to be a sensible and reasonable investment. Three decades of studying the capital markets has taught us our most important investment principle: keep things simple.

In the April edition, we will discuss some of the worst mistakes ETF investors should avoid.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.