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What are ETFs? Exchange Traded Funds (ETFs)
began in 1993. They became a low-cost alternative
to mutual funds since they are not actively
managed. Rather they are designed to mimic key
indices such as the S&P 500 or the FTSE. Traders
use these as an inexpensive way to diversify across
a wide range of assets. Since the first ETF, these
assets have multiplied and now you can find
hundreds of ETFs for dozens of asset classes.
How Are ETFs Created? Unleveraged stock ETFs
are typically formed by an institutional investor.
They often create an ETF by borrowing large
blocks of stock (25,000 to 200,000 shares
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) from
a pension fund. The block of assets in this ‘creation
unit’ are in the exact ratio of the index they want to
duplicate. The ETF trust then issues shares which
have legal claim on the shares in the trust.
When mergers or acquisitions happen with
companies in the index, funds need to rebalance.
If some assets overperform or underperform in
the ETF, they are sold or bought to keep the fund
in the same ratio as the index it follows. Managed
ETFs might rebalance quarterly. Traditional ETF
may rebalance once or twice a year.
Tax Advantages: ETFs have more tax advantages
than open-ended mutual funds. When a trader
sells their shares of mutual funds, the underlying
stocks are sold and the cash given to the owner.
This can create capital gains for every holder of
that mutual fund. With ETFs, the buying or selling
of the share does not change the ownership of the
underlying assets.
ETFs usually sell for close to the total value of the
index they follow. If you add up the per share value
of the stock of each company in the fund, the
fund’s price should be very close to that number.
If it rises (premium) or falls (undervalued) by more
than a small amount, institutional investors step
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Shreck, Mara and Antoniewicz, Shelly ‘ETF Basics: The Creation and Redemption Process and Why It Matters’, Investment Community Institute,
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in. They take advantage of that small difference.
Their arbitrage buying or selling brings the price
back into line.
Lower Costs: ETFs most often have lower
associated costs than the same kind of mutual
fund. In addition to the tax savings mentioned
above, you save on:
Management fees. They have no research costs
and are un-managed
Commission costs. Fewer shares are traded
Entry costs. You can buy just one share instead
of a minimum order for mutual funds.
Fully invested. ETFs can put all their money to
work. They don’t need to hold out a reserve to
pay for redeemed shares
Bond: Investors can buy a wide range of bond
funds. They may choose funds based on bond
length: short, intermediate or long. Other bond
ETFs invest in bonds of different nations, from China
and Australia, to California Muni and international
corporate bonds. You can find bonds based on
money markets, maturity dates, and mortgage
backed. For investors who want to diversify into
any broader market, there’s an EFT for that.
Currency: Currency ETFs give investors an easy
way to enter the currency market. They can choose
an ETF that holds futures contracts for a specific
currency or ETFs that invest directly into a currency,
or a group of currencies. Both have the goal of
matching the performance of a certain foreign
currency, rather than beating performance. If you
think a currency will rise or fall, an ETF can be a
simple way to try to take advantage of the move.
10.1 Kinds of ETFs
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Commodity: Commodity ETFs give investors
exposure to agricultural products, energy
resources and precious metals. An investment in
copper, crude oil, or gas is different from investing
in a company that produces or manages it. Unlike
equity ETFs, commodity ETFs seldom own the
underlying asset, with the exception of gold and
silver. Some funds actually own the precious metals
stored in vaults.
More typically the ETFs buy futures contracts for
oil, soybeans, or whatever commodity or index it
follows. Futures lose premium value as they get
closer to their expiration date. This premium loss
can add up over time, making these ETFs best for
short term investing. If you want to hold oil or other
commodities long term, you may be better off with
an equity ETF.
Equity: Many investors use ETFs to diversify into
different asset sectors ranging from energy, to
financial, healthcare, or industrials. Check your
investment strategy and find ETFs that give you
exposure to different sectors. It pays to review
the stocks in the index your ETF follows to avoid
duplication. Some ETFs invest based on size, such
as small, mid, or large cap, or they may focus on
value investing or new technology.
Region: Choose ETFs that are located where
you think markets might outperform: Europe,
China, India, or perhaps the Middle East. You
can invest in country-specific ETFs or in a basket
from developing countries or emerging markets.
Worldwide diversification helps broaden your
portfolio to different trends. ETFs make it easier to
hold equities from foreign countries, especially if
the stock is not traded on your country’s exchange.
Real Estate: You can gain easy access to real estate
exposure with real estate ETFs. With this method,
there’s no need to worry about a down payment
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or mortgage payments. Many Real Estate ETFs
seek to mimic the performance of certain indices.
Most ETFs do this by buying REITs (Real Estate
Investment Trusts).
These companies either own physical properties or
they hold mortgages to properties. The properties
within an ETF may be held based on location,
business, or size. Some might focus on hospitals,
other on malls in New York, or apartments
in London. They may also be companies that
manage properties. Real Estate ETFs can look for
high returns, potential growth, or acquisitions.
Remember that all investment carries risks and
there are no guarantees.
Volatility: These ETFs try to mimic the volatility
of the Volatility Index (VIX) or other volatility
measurements. Since they often move inversely to
the major market indicators, they can be attractive
for day trading. For example, if the markets rise,
volatility often falls. Most of these ETFs are based
on exchange traded notes which have no assets
behind them. These ETFs do an imperfect job of
following their indices and can involve a lot of risk.
Because of premium decay on futures, these funds
are not recommended for long term holding.
Actively Managed: These ETFs have portfolio
managers who more actively balance the ETF by
buying and selling. This is in an attempt to achieve
a specific objective. In this case, they seek to
beat the market or the index. While they still take
advantage of the ETF benefits, management fees
rise a little. ETFs began because the indices often
beat managed funds. It’s possible the managed
ETFs can cost more and produce poorer results.
With hundreds of ETFs to choose from, you can find
ones that fit your risk level, your portfolio, and your
diversification strategy. You can check out different
ETFs at the etoro.com ETF page. Remember,
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all trading involves risk. Only risk capital you’re
prepared to lose and of course, past performance
does not guarantee future results.
While traditional ETFs seek to mimic the indices
they follow, inverse ETFs want to do the opposite
of the index. If the index goes down, the ETF should
rise by the same amount. And leveraged ETF
want to do it times two or three. These funds use
leverages and hedges to accomplish their goals.
Their design and makeup are different from simple
stock ETFs.
Inverse ETFs: An inverse ETF is designed to give
you profits when the underlying asset drops.
Investors may use this as a hedging tool against
market corrections. For example, if the FTSE goes
down £10, the inverse FTSE fund such as XUKS
would hopefully rise by £10. Double (SUK2) or triple
inverse (UK3S) ETFs hope to multiply the drop by
returning you £20 or £30 for each £10 drop.
These funds are sometimes called ‘short’ or bear
ETFs. They do not hold the FTSE or underlying
assets. Rather they use transferable securities,
derivatives, and swap agreements. It takes active
management on a daily basis, so the fees for these
ETFs are much higher. Often they are 1% or more.
The funds rebalance their assets on a daily basis to
keep the inverse with that day’s move of the index.
This daily rebalancing means that each day’s
move is a separate event. It can lead to an extra
percentage, or more in a fall over a few days.
However, the ETF will lag in the rebounds giving
you poorer performance. It’s a highly sophisticated
tool often best used very short term or left to
professionals. There are other ways to short
a market. Statistically, if held long term, they
10.2 Leveraging ETFs
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disappointingly underperform.
42
Leveraged ETFs: A leveraged ETF is designed
to give you two or three times the return of the
underlying asset. These ETFs may be called Ultra
2x, or double long. The funds work by both holding
some of the asset and through swap contracts.
These create a ‘notional exposure’ that is two or
three times the daily return of the index or asset.
At the end of each day the fund must rebalance to
maintain that notional exposure.
This leverage can work both for ETFs seeking to
track the market and those wanting to short the
market. The promise of double or triple returns
may work for a day or in a very strong up or down
movement over a few days. But the longer it is held,
the less likely you are to get the results you want.
For example, here are two funds that track the
MSCI Emerging Market Index:
Short MSCI Emerging Markets ProShares (EUM)
UltraShort MSCI Emerging Markets ProShares
(EEV)
They are designed to go up if the index goes down.
Yet in 2008, when the index lost 52%, the short
EUM gained only 20%. Meanwhile, the UltraShort
not only didn’t go up 100%, but it also lost 25%!
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This is not unusual. Rather, it’s typical for leveraged
ETFs.
Part of the problem is that the funds are designed
for one day use, and this is an annual return. The
reason they fail is that the returns are compounded
daily on market uctuations. The chart in Chapter
2 reminds us how much assets must gain after a
loss to come back to even. A 30% loss needs a gain
of 43% to recoup the loss. When the underlying
asset returns to break-even over a period of days,
the ETF can’t make up the difference.
42
Justice, Paul, ‘Warning: Leveraged and Inverse ETFs Kill Portfolios’, Morningstar 22 Jan 2009
43
See Note 42.
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Paul Justice, writing for Morningstar says:
With virtually every leveraged and inverse fund, I
can tell you that they are appropriate only for less
than 1% of the investing community. Considering
that these funds have attracted billions of dollars
over the past year alone, it’s pretty obvious that
too many people are using these incorrectly.
…[W]henever you hold these ETFs longer than
their indicated compounding period (typically one
day for stock-based ETFs, sometimes monthly
for commodities), you are almost mathematically
guaranteed to get a return that is not double
that of the index. In fact, the longer you hold one
of these funds, the probability that you will get
nothing close to double the returns increases.
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A simple way to take advantage of ETFs is to buy
and sell them on the stock market or on a trading
platform such as eToro. One benefit to this method
is that you can use leverage and short selling
ETFs in retirement accounts that might prohibit
short selling in other ways. And buying leveraged
ETFs only exposes you to the potential loss of
your investment. This is different from options or
leveraged CFDs that can create a loss far greater
than your investment.
However, CFDs offer an alternative way to trade
ETFs. These Contract for Differences allow you to
trade based on the price change of the index or
ETFs. Since you can arrange a contract at a fixed
price, it’s easy to short the indices or ETFs. With
CFDs you also have access to many funds that are
normally outside the reach of your local securities
exchange.
The low-cost, transparent nature of ETFs make
10.3 Trading ETFs
44
ibid.
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have an inexpensive entry point and it’s easy to
see the kinds of assets you are buying. However,
when you move into leveraged and inverse ETFs
you gain more risk. The rewards and risks are
multiplied. While the leveraged ETFs clearly tell
traders they are rebalanced daily, few investors
understand this kind of leverage is unlikely to
work over the long run.
Consider ETFs as just one aspect of a balanced,
risk-adjusted portfolio.
Your capital is at risk. Past performance does not guarantee future results. This information is for educational purposes and not investment advice.
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