In the Part I of our ETF Guide we looked at the basics of exchange traded funds, their advantages for investors, the various types of ETF funds as well as the somewhat newer additions to the ETF universe – equally and fundamentally weighted ETFs and actively managed ETFs. (You can read ETF Guide - Part I here.)

Today we look at the benefits and risks of the more complex ETFs that have become increasingly popular in the last few years.
New generation of ETFs – new risks
Although exchange traded funds (ETFs) were first introduced as passive, low-cost, transparent investment vehicles, today investors also have access to a number of highly complex ETFs. While their popularity with traders and experienced investors is growing, it is essential that you fully understand the risks before investing in these more exotic vehicles.

Compared to traditional ETFs, this new generation presents (often significant) additional risks. Read on to learn about leveraged ETFs, inverse (short) ETFs, futures-based commodity ETFs, ETNs and ETCs, and ETFs of ETFs. Finally, we also show you the main risks you will be exposed to with certain types of ETFs. These are frequently misunderstood by investors and could result in a loss of your capital!

Leveraged and inverse ETFs have attracted plenty of criticism. Although they are simple to use, their very complex structure may be difficult for retail investors to understand. While they are undeniably complex and quite different vehicles from the original, transparent funds, they have their place in an informed investor’s arsenal.

Leveraged ETFs

Leveraged ETFs have only been available for a few years and are generally used by traders. They are designed to amplify the returns of an underlying index by using debt and derivatives (usually futures or swaps). The financing provides greater exposure; typically the leverage ratio is 2:1 or 3:1.

So, for example, the daily return (before expenses) of a two-times leveraged ETF should be twice that of the underlying index – that goes both for gain and loss. Since these instruments exaggerate market movements they can be very volatile.

Leveraged ETFs require daily rebalancing to maintain a constant leverage ratio. That, combined with high volatility, can erode gains over time, so they are best used for short term trading.

(While leveraged ETFs deliver a multiple of the index’s daily performance, over long term, due to the compounding effect of leveraged performance, they tend to deviate significantly from the underlying index.)

The constant buying and selling of derivatives result in transaction and interest expenses, on top of the management fee. There are both long and short leveraged ETFs. Due to their high volatility and risk investors should use them with care.

Inverse ETFs

Inverse – or short – ETFs are designed to return (before expenses) the opposite of the benchmark they track. For example if the S&P 500 declines by 2% an inverse S&P ETF would rise by 2%, and vice versa.

Inverse ETFs therefore offer investors an opportunity to benefit from falling markets. They can be used speculatively, to bet on decline of the underlying index, or for hedging purposes.

Buying an inverse ETF provides similar results to short selling the index. However, while short selling exposes a trader to potentially unlimited losses, an inverse ETF exposes him only to the loss of the purchase price.

There are inverse sector ETFs, index ETFs, commodity ETFs, etc. Like leveraged (and other complex) ETFs, inverse funds have higher expense ratios than simple ETFs – though typically still lower than mutual funds.

Short selling

Unlike mutual funds, many ETFs can also be sold short – just like stocks.

Like buying inverse (or short) ETFs, short selling (or shorting, going short) traditional ETFs is used for hedging and speculation. Investors can hedge their portfolios against downside risk in declining markets, reducing losses on their long positions. Short selling also offers an opportunity to profit from betting on falling markets.

Shorting is the process of selling securities that the trader has borrowed (rather than owns). When expecting the price to drop, short sellers sell the borrowed securities at the current (higher) price and hope to buy them back at a lower price at a later date. They then return the securities to the lender and the difference is their profit. If the prices rise instead of decline, short sellers incur a loss.

Futures-based commodity ETFs

Commodity ETFs (tracking the performance of a commodity or basket of commodities) either hold the physical commodity or use futures contracts to gain their commodities exposure.

Commodity ETFs that use futures often diverge significantly from the price of the benchmark they are designed to track. This high tracking error is mainly due to contango and backwardation related to futures, leading to losses from rolling futures contracts in contangoed markets and gains in backwardated markets. (For further explanation read here.)

(For example, the highly popular US Oil Fund ETF (USO) has consistently failed to deliver what it had promised – tracking the price of crude oil – due to these phenomena.)

Futures-based commodity ETFs are taxed differently than most other ETFs, so check carefully before investing. (More information here.)

ETNs (Exchange traded notes) and ETCs

Exchange traded notes – or ETNs – are debt instruments linked to the performance of an index, commodity or currency. They have been around since 2006 and can be bought and sold through a broker, like stocks and ETFs.

ETNs, due to their structure, are very flexible and offer easy access to hard-to-reach assets such as commodities or countries that impose limits on foreign investment.

The main difference between ETNs and ETFs is that, as debt notes, ETNs don’t actually own any assets. Instead, the issuing bank promises to pay the ETN buyer the amount reflected in the index, minus fees.

Commodity ETNs (also ETCs – exchange traded commodities) offer certain advantages over (futures-based) commodity ETFs. Their price closely tracks the underlying commodities index, removing the tracking error often seen in commodity ETFs. So with ETNs investors can generally get what they planned for – the return of the index (minus management fee). They may also offer certain tax advantages (to US investors), compared to futures-based commodity ETFs.

However, investors need to understand that the creditworthiness of the issuer is very important here. ETNs are debt obligations and as such subject to the solvency of the issuing bank. If the issuer’s financial condition deteriorates, it can negatively impact the value of the ETN. If the issuer goes bankrupt, ETN holders may lose their capital. (Investors in ETCs are exposed to the credit risk of the guarantor.)
ETFs of ETFs
One of the newest products in the ever expanding ETF universe are ETFs of ETFs, available since 2008. These funds of funds offer different asset allocation strategies and risk levels to investors. In principle they provide a more diversified portfolio in a single product.

However, there are a few things to keep in mind. ETFs of ETFs can compound fees, since the fund’s expense ratio is applied on top of the expense ratios of the ETFs held by the fund. They can also push ETFs that have not proven popular with investors and are being repackaged in this way by the issuer. Not surprisingly, the fund’s issuer will typically give priority to their own ETFs when constructing the fund.

More innovations – hedge fund ETFs

Last year Deutsche Bank launched the world’s first hedge fund ETF. It tracks the bank’s proprietary db Hedge Fund Index and is linked to the performance of its constituent hedge funds. There are now a few more hedge fund ETFs on the market. While direct investment in hedge funds is out of reach of most investors (due to large minimum investment requirements), the ETFs are accessible to anyone.
ETF benefits for traders
Traditional ETFs have proven popular as basic building blocks in long term investors’ portfolios.

However, thanks to their trading flexibility, liquidity and convenience, ETFs are also widely used by traders to go long or short on indices or specific sectors. Options can also be written against many ETFs, just like with stocks. Double- and triple-leveraged ETFs are a good, low cost tool for day traders who understand how to use them properly.
RISKS: What you need to watch out for when buying ETFs!
When buying ETFs it’s not enough to consider what a particular ETF invests in.  Investors must understand the structure of each ETF before putting in any money. As discussed earlier in this article, there are many variations in structure and execution, and as a result the risks differ vastly.

Below we sum up the most frequently misunderstood risks related to specific ETFs.

1. Tracking errors

While all funds have a certain tracking error (deviation from the underlying benchmark), futures-based commodity ETFs sometimes completely fail to track the underlying commodity (chiefly due to contango and backwardation in futures markets). See section on Futures-based commodity ETFs. Leveraged ETFs track the daily performance of the index but will deviate significantly over longer term (see section on Leveraged ETFs).

2.  Counterparty risk

As with most investments, ETF holders are exposed to market risks related to the securities the funds track. However, with some products, there are additional counterparty risks investors need to be aware of.

ETF holders will remember autumn 2008, when the near demise of AIG resulted in a number of ETCs (exchange traded commodities) – that were guaranteed by the US insurer – being temporarily suspended from trading, due to concerns that AIG wouldn’t be able to meet its contractual obligations. (Trading resumed after the Fed’s bailout of AIG.)

So how concerned should you be about counterparty risk in relation to ETFs? And, which ETFs are at risk?

First of all, it’s important to distinguish between physical or ‘cash-based’ ETFs, swap-based ETFs and ETNs/ETCs.

Cash-based ETFs are very transparent and hold the underlying securities of the index they track. In case of the provider’s failure investors have recourse to the fund’s ring-fenced pool of underlying assets.

(US physical ETFs must hold 100% of the underlying securities, meaning the investor is exposed to no counterparty risk. In Europe they can use derivatives but must hold a minimum of 90% of the fund as collateral, limiting any counterparty risk to a maximum of 10% of the fund’s net asset value.)

Swap-based ETFs invest in derivatives, offered by third parties, to provide exposure to the index. They hold a basket of securities (to which investors have recourse in case of issuer’s failure) and an index swap. In the EU (under UCITS rules) investors’ exposure to the risk of counterparty default is limited to a maximum of 10% of the fund’s NAV per counterparty.

(Note: swap-based ETFs have their advantages; they tend to be more efficient, with lower cost and lower tracking errors than ETFs that hold the underlying index constituents or futures contracts.)

Then there are ETNs (and ETCs). Investors in exchange traded notes are directly exposed to counterparty risk of the note issuer. (See section on ETNs earlier in this article.) ETC investors are exposed to third parties guaranteeing the securities’ performance (AIG in many ETCs).

Risk is sometimes reduced through collateral, but in some cases investors could lose their capital in case of the issuer’s bankruptcy. (Note: A few precious metal ETCs are backed by physical holdings, eliminating counterparty risk.)

While most ETFs are reasonably safe for investors, it would be good to see more disclosure in the industry. For example, many ETF providers don’t disclose who the counterparties are in their funds, what percentage of the fund relies on uncollateralized swaps, how often collateral is rebalanced, etc. This is something investors should have the right to know.

Finally, below are answers to a few frequently asked questions related to ETFs.

What’s the difference between NAV and the market price?

Net Asset Value (NAV) refers to the fund’s total assets minus its liabilities; market price is the quoted price the ETF is trading at. Although large premiums or discounts are rare, NAV and market price will diverge at times.

How liquid are ETFs?

The liquidity of ETFs depends mainly on the liquidity of the underlying securities, rather than the trading volume of the ETF itself.

ETFs allow units to be created or redeemed reflecting supply and demand. Therefore their liquidity comes from the creation/redemption process and/or trading on exchange. ETFs with low trading volumes can still be liquid and traded with ease.

Do ETFs pay dividends?

Yes, depending on the index they track. The dividend income received from underlying stocks or bonds is distributed to ETF shareholders or (if the ETF tracks a Total Return Index) reinvested.

Do ETFs influence asset prices?

Some analysts believe certain ETFs can cause market bubbles. While it is beyond the scope of this article to explore this in depth, it’s worth noting, for example, that the world’s second largest ETF, SPDR Gold Shares ETF (GLD), now holds 1,117 tonnes of gold bullion (more than the central banks of China, India, Russia or the EU). The ease of exposure to gold, at low cost, has resulted in investors and speculators to funnel massive amount of capital into GLD. Due to its size GLD’s trading activity can heavily influence the global gold price.

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If you are interested in stock market investing, chances are you have heard of, or even invested in, ETF funds.
What is an ETF?
Exchange traded funds (ETFs) have only been around since 1993, when the first ETF was introduced. That original ETF (SPDR S&P 500 ETF, by State Street Global Advisors) is still one of the most popular today. In recent years ETF funds have become increasingly popular as an alternative to mutual funds.

ETFs are low cost index funds that are listed and trade on major stock exchanges, just like stocks. They are made up of a basket of securities, similarly to mutual funds. However, an ETF has its own ticker symbol and can be bought and sold, during market hours – like an individual stock – through your broker (including discount online brokers). (A standard brokerage commission to buy or sell will apply.)

ETFs track a variety of stock, bond, commodity and currency indices. Some ETFs track the performance of a broad index (e.g. the S&P 500, FTSE 100, etc), others are more narrowly focused on a specific sector, company size, or even a country or region.
Why invest in ETFs?
ETFs have become increasingly popular with both individual and institutional investors, as well as traders and other financial professionals. Despite the jump in money flows into ETFs, they are still small compared to the amount of money invested in mutual funds.

So what are the main advantages of ETFs?

• low expenses
• tax efficiency
• diversification -> reduced risk
• transparency, trading flexibility and  liquidity
• instant, low cost exposure to global markets
• exposure to specific sectors, industries, investing styles, etc
• access to long & short strategies

While mutual fund managers try to beat the benchmark index each year, ETFs aim to mirror it.

Which is not a bad thing considered that a vast majority of fund managers under-perform the market averages, and even top managers rarely sustain their excellent returns over time. Trying to outperform the market – especially after fees – is difficult, and most managers don’t succeed.

Most investors tend to be better off buying an index ETF, which is low cost and will ultimately outperform most active managers.

One of the most important decisions for an investor is the right asset allocation for his portfolio. ETFs are well suited here, allowing active investors to easily adjust their asset allocation as markets (and risks) change, increasing or cutting exposure fast.

Since ETFs trade on exchanges, you have the advantage of the same types of trades (long, short) and orders (incl. limit, stop, stop loss, etc) as with an individual stock. Many ETFs also have the capability for options (puts and calls) to be written against them.

The diversification of most ETFs reduces investment risk. Every individual stock is only part of a basket, hence ETFs are generally less volatile than individual stocks.

Importantly, there is no minimum investment requirement, so you can buy as much or as little as you wish.

Expense ratios

Buying and selling fees:

• ETFs – standard brokerage commission

• Mutual funds – between 0 and 5% (on purchase)

Management fees:

ETFs tend to have a significantly lower expense ratio than mutual funds.

• ETFs – annual fees of 0.1 – 1%

• Mutual funds – 1-3% p.a.

(Expense ratios of ETFs vary, so make sure to check each fund’s prospectus.)

You would not believe how much this saving adds up over the long term!

Often investors don’t realize that costs play a huge role in reducing their returns. Commissions, load fees, advisory fees, management fees, taxes, etc… when added up, they will reduce overall investment returns very significantly.

Tax Advantages

One often overlooked issue is the high amount of taxable transactions in most mutual funds. Actively managed mutual funds have high turnover of their portfolio, and more trades result in not only higher transaction fees but also additional taxation. (The tax is deducted from the investors in the fund, even when they don’t sell their shares.) This, along with all the other costs and fees means a significant reduction in a fund’s return.

ETFs are usually more tax efficient than mutual funds. They are generally designed to track benchmark indices, and as such make fewer trades. The low portfolio turnover reduces the frequency of tax gain distributions.

(In the US, whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the fund must distribute capital gains to its shareholders. These gains are subject to taxes, even if you reinvest the distributions in more shares of the fund. ETF investors, on the other hand, only realize capital gains when they sell their shares in the ETF, when the ETF changes holdings in its underlying index or when stocks are removed from/added to the index.)

So instead of looking at the reported pre-tax returns of actively managed funds, compare after-tax returns of available investments before you decide where to put your cash.

(Note that US taxation of commodity ETFs is more complex and varies depending on their structure. Some commodity ETFs own the physical commodity and are taxed at a long term capital gains rate. Others use futures contracts to gain their commodities exposure; these are taxed every year, even if you don’t sell, at a hybrid rate -60% of your gains are taxed at the long term capital gains rate and 40% are taxed as short term capital gains.)

Please note that this is not meant as tax advice and may not be correct at the time of reading. Speak to your tax advisor before making any investment decision.
Who issues ETFs?
There are a number of companies providing ETFs. Among the best known are Barclays Global Investors, Vanguard, State Street Global Advisors, Fidelity Investments, Credit Suisse, Deutsche Bank, Lyxor, and many others.
Types of ETFs
When doing your research on ETFs, read the prospectus and information found on the issuer’s website. There are many different types of ETFs, depending on what the fund is tracking but also how the securities are weighted, whether there is any additional risk exposure, etc. Make sure you understand what exactly you’re buying before you invest.

ETF types:

Index ETF

The most common type of ETF, an index ETF tracks a specific US or foreign stock index (e.g. NASDAQ 100, FTSE 100, S&P 500, Russell 2000, etc). There is a large variety of index ETFs for investors to choose from.

Sector/industry ETF

These ETFs represent a specific sector (industry group), e.g. technology, energy, materials, industrials, healthcare, financials, utilities, consumer staples, etc. They track the collective performance of that industry. As with most other ETF types, there are US as well as foreign and global sector ETFs.

Size-specific ETF

These ETFs are defined by the market capitalization of the individual stocks within. For example large-cap companies (generally over $10 billion in market cap), mid-cap companies ($2 bil to $10 bil), small-caps ($300 mil to $2 bil), micro-caps ($50 mil – $300 mil).

Country-specific ETF

These ETFs track the performance of the markets of an individual country, or, in some cases, an entire region (e.g. Eastern Europe, Eurozone, Latin America, Asia, etc). There are numerous international ETFs listed both on US and foreign stock exchanges.

Commodity ETF

Commodity ETFs track the performance of a commodity (e.g. oil, natural gas, gold, silver) or a basket of commodities (such as precious metals, base metals, agricultural commodities, etc).

As discussed in the tax section above, you need to make sure you fully understand how the commodity ETF is structured. While some own the actual commodity, others are futures-based. Risks as well as tax implications will therefore vary.

Currency ETF

A currency ETF provides investors the ability to track the performance of various currencies throughout the world, such as the US dollar, Japanese yen, British pound, Euro, etc. (It’s important to note that while FOREX is essentially a 24hr market, currency ETFs are available for trading only during stock market trading hours.)

Fixed income ETF

ETFs that track corporate bond or treasury bond indices.
ETFs by weighting model
Equal-weighted ETF

Most ETFs (and indices) are weighted by market capitalization, meaning that larger companies have much greater representation in the index and greater influence on the price movement. Most of the index’s capitalization is concentrated in the top holdings.

A few providers now offer equal-weighted (index and sector) ETFs, which give a broader representation of the companies within the index. Each stock is initially given an equal weight, allowing you to spread your risk equally among all the stocks in the index. It also means you get more exposure to smaller and midsized companies, which often outperform the larger caps.

The other issue with market cap weighting is that stocks that have quickly risen in price and become overvalued will have higher weighting in the index. (The higher a stock’s valuation, the higher is its market cap.) Equal-weighed ETFs avoid overweighting stocks that trade above their fair value.

To maintain equal weighting, the ETF needs periodic rebalancing (generally done on a quarterly basis).

This means that such ETFs (compared to traditional index ETFs) usually have higher expense ratios, as well as higher bid-ask spreads (since they tend to be more thinly traded). As rebalancing involves selling stocks that have appreciated most, it results in higher transaction fees but also higher tax liability (due to realization of capital gains).

While equal-weighted ETFs are a great addition to the ETF universe, they tend to be slightly more expensive as well as less tax efficient, all of which can result in a lower compound return. Investors need to examine carefully whether these ETFs will benefit their portfolio.

Fundamentally weighted ETF

While traditional indices are market cap weighted, fundamentally weighted ETFs offer an alternative, weighting companies based on fundamental factors (such as book value, earnings, dividends, etc).

Some ETFs are weighted to fit a certain investment style. For example, there is a range of value ETFs which select companies based on combinations of price/earnings, price/book, price/cash flow ratios, dividend yield, etc.

As we have seen with equal weighting, ETFs that are weighted other than by market cap tend to have a higher portfolio turnover (since they have to buy and sell holdings as prices fluctuate). This results in increased transaction costs and lower tax efficiency; both generally apply to fundamentally weighted ETFs as well.
Actively managed ETF
Actively managed ETFs have been around since 2008 and have so far not proved very popular with investors. These ETFs, instead of tracking an index, use a manager to select the securities to be included in the fund.

Actively managed ETFs present similar issues as traditional actively managed mutual funds… the expense ratio and transaction costs are higher, and tax liabilities are higher.

Therefore, the manager has to add up enough value to make up for this. Now, as we can see with most mutual funds, that rarely happens. Since most managers don’t do better than market averages, the benefits of actively managed ETFs may be questionable (at least until we start to see some track record of these funds).
Coming in Part II…
While ETFs were first introduced as passive, low-cost, transparent investment vehicles, today there is also a number of highly complex ETFs. Some of them have proved very popular with traders and experienced investors, but it is essential that you fully understand the risks before investing in these more exotic vehicles.

They include leveraged ETFs, short ETFs, futures-based ETFs, ETNs (exchange traded notes), ETFs of ETFs… And we’ll tell you all about them, including the pros & cons and things to watch out for, next week, in Part II of this ETF guide.

In the meantime, if you have any questions about ETFs (or indeed any investments), simply write it in the comment box below and you’ll get an answer asap. (Alternatively you can always write to info (at) moneyhoneyblog.com.)

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