Beware of ETF’s


Beware of ETF’s

By Neil George

The ETF Sales Pitch
Seemingly every fund management company has come out of the woodwork with ETF’s that are supposed to provide investors with an easy means of investing in just about any particular market sector, index or even themes.

Over the past several months, these supposedly index-linked investment vehicles have been repackaged – and with the permission of US regulators, have become so flexible and in some cases managed – that they’re not even indexed to anything.

And whether an ETF is linked to an index or not, it can of course also supposedly be created to perform at a multiple of an underlying basket of securities or index – or, even to perform in the opposite direction.

Billions upon billions of dollars have been spent on advertising and pitches to buy into this supposedly new form of investing.

The idea is that rather than having to actually pick out stocks to buy or sell – you can just buy an ETF and have it all done for you.

And, so the pitches go, ETF’s are really much cheaper than investing in a mutual fund – closed end or open end – because all the managers have to do is put together the ETF based on an index and let the market price them. So, it’s almost like investing for free.

No wonder that so many investors – even supposed professionals – buy and hold ETF’s across many markets. Because (if you take the sales literature at face value) they’re cheap, easy and the modern way to run a portfolio.

Except that they’re not.

What the Pitchmen Don’t Tell You

To understand why, let’s look first at the core of what makes for an ETF.

An Exchange Traded Fund might have a great name on the outside – but most investors will never, ever be able to find out what’s actually inside them.

That’s because the folks that build and run ETF’s will only release what’s really in them to the specialist traders that sign on to make markets in them.

While ETF’s trade on exchanges and folks think that they’re buying or selling at the net asset values of the moment – the truth can be far and away different.

That’s because throughout the day, few folks actually know what’s inside the ETF’s underlying assets, which are embodied by what are called “Creation Units.” Each Creation Unit is what is used to deliver an ETF share to the market. And, each share of an ETF actually is just a share in the underlying real basket of assets.

Those assets can vary widely throughout the trading day and are not usually made up of actual stock shares – but rather a series of options, swaps, forwards and a host of other derived securities, in amounts and proportions that only the specialists and the managers of the ETF know about.

Traders in the know love these things because they get to trade against the underlying basket of assets. They get to buy, sell, short and everything else that can enable them to arbitrage against the secret baskets of assets behind every ETF.

So, while you might think that you are buying or selling an ETF at the real value of the index that it’s supposed to be linked to – you really will never, ever know for sure.

And when it comes to markets not priced up to the moment – say, foreign stocks or bonds – not only do you have the uncertainty of the underlying murky mix of derivatives that really back up an ETF, but you also have the uncertainty of what the supposed basket of assets might be priced at.

In past years, I’ve seen some Asian ETF’s trade at premiums and discounts amounting to over 30 percent away from what should be their real market prices.

So, not so easy, are they?

But it gets worse.

Severe Under-performance Against Benchmarks and Alternative Vehicles

While the performances of ETF’s can track underlying indexes – they often under-perform. And when you match up many ETFs against closed-end funds focused on the same or very similar markets, ETF’s tend to lag.

One prime example can be seen in a past recommendation in the Brazilian market that worked out quite well for my subscribers years ago. I recommended buying and owning a closed-end fund called The Brazil Fund for years – selling it in 2006. The returns for that fund, held for 5 years, were just shy of 300 percent.

Now, if you had been reading my stuff back then, and instead of buying my fund recommendation, went along with an ETF supposedly tracking the Brazilian market trading as the Brazil iShare – you would have made money – but with less than half of the return of the fund and the market.

This lag in performance is bad enough for non-leveraged ETF’s – but can get even worse for leveraged ETF’s and more so for ETF’s that supposedly move in an opposite fashion to an underlying index or basket of assets.

Another Enemy of ETF’s: Time

The key for all of the ETF’s is that the longer the period of time you look at their performance, the worse they match up against their objectives. If you were to look at any of the above ETF’s on any given day, there is a greater propensity for them to track what they’re supposed to track. But as you move out from 1 day to 2 days and so on – the correlation begins to break down very quickly.

The lesson here is that ETF’s can make for great trading fodder for those who are privy to the real underlying asset mix of the underlying creation shares. That’s how – and by whom – real money is made in ETF’s.

For the rest of us mere mortals, we’d all be better served to steer our portfolios away from the pitches of Wall Street and instead follow the move by one of the biggest creators of ETF’s – Barclays – which earlier this year dumped its ETF fund operations.

About the Author:

Neil George is editor of the weekly e-zine By George: Profits Hidden in the News. He is also editor of the website Stocks That Pay You, which is devoted to finding high-dividend stocks, bonds and other securities that possess a high degree of safety. Neil is a fierce advocate for first selecting higher-yielding securities, then narrowing his recommendations to only those companies which can pass his stringent, proprietary financial stress tests.
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