NEW YORK, May 9 (IFR) - Exchange Traded Funds, or ETFs, have operated fairly well historically and have been a good tool to take advantage of investment themes by allowing an investor to take on a more tactical approach to the markets.
These complex vehicles offer investors all the benefits of stock trading, such as intraday execution, increased flexibility to short or invest on margin, and lower expenses when compared to traditional mutual funds.
Even with all these benefits, investors need to recognize some of the risks that are not obvious or publicized until extreme events take place.
ETFs’ popularity in challenging actively-managed mutual funds grew from their ability to be traded during market hours, making them a valuable tool in situations when immediate execution is sought. This sounds great but can be misleading to investors who are less informed about the quality of the ETF, where the ETF is invested, and its liquidity.
An ETF’s liquidity is determined by the trading volume of the securities it holds and by the trading volume of the ETF itself within an investment environment.
As with any financial security, each ETF has a different level of liquidity. When underlying holdings are traded less frequently — a common issue with fixed-income ETFs — the ETF returns may diverge from the benchmark it is designed to track.
Unlike mutual funds, a lack of liquidity in an ETF can lead to wide bid-ask spreads or may cause the ETF to trade at a large premium or discount to its net asset value.
This occurred in the summer of 2009 when the world’s largest natural gas ETF, the United States Natural Gas Fund — ticker symbol UNG — suspended an offering of new shares on concerns that federal regulators would keep it from investing in natural gas futures. That move forced UNG investors to pay an elevated premium to its underlying net asset value.
The flash crash on May 6, 2010 was a day of reckoning for many investors when structural issues with ETFs became apparent.
The allure of ETF liquidity became a huge liability for investors that day as ETFs were badly overrepresented among the canceled trades and the sector afflicted with extreme price volatility.
About two-thirds of the erroneous trades involved ETFs and about 20% of all ETFs that day experienced some type of trading glitch in which the securities departed from their perceived value.
About 210 of 980 ETFs changed hands at a price more than 50% below their ultimate closing price, according to Morningstar. There were no mutual funds and, surprisingly, there were no actively managed ETFs impacted by forced cancellations during the flash crash.
The fallout for ETF shareholders during the flash crash also depended on whether they were long-term investors or day traders with quick trigger fingers who decided to sell when the market was crashing.
Many investors who had stop losses with good-till-cancel orders saw those positions sold at hefty losses. However, the majority of ETF investors, those who avoided panicking or did not have limit orders, were able to emerge from the crisis relatively unharmed once the market stabilized.
As ETFs have evolved into more esoteric areas of the market, volatility and relative underperformance have been apparent even in normalized trading environments.
Leveraged ETFs are a prime of example of a strategy that has gained popularity but has also caused headaches for many uninformed investors. These leveraged ETFs, often referred to as 2x or 3x, use derivatives and other complex financial instruments to provide amplified daily returns on a target index.
For example when index XYZ goes up 2%, a 2x ETF is expected to return 4% and a 3x ETF is expected to return 6%. This should be reason enough to be cautious as magnifying gains through leverage may be appealing, it can just as easily magnify losses.
It is important for investors to understand how trends, volatility, and holding periods affect returns for leveraged ETFs. Leveraged ETFs can fill a need for a sophisticated day trader but are not suitable investment for an investor with a time horizon longer than a few days. This is because leverage costs money and that will come out of the total return over time based on the daily volatility component.
Small percentage moves produce negligible value decay to the share price as the ETF resets daily to track an index. Without a sustained trend on the underlying index an investor is going to lose money over long periods by holding leveraged ETFs longer than their indicated compounding period (typically one day).
The 630-page prospectus of one of these leveraged ETF providers states numerous risks associated with these ETFs, in particular the effects of compounding and market volatility risk.
“The Fund does not attempt to, and should not be expected to provide returns which are a multiple of the return of the Index for periods other than a single day...
“Over time, the cumulative percentage increase or decrease in the value of the Fund’s portfolio may diverge significantly from the cumulative percentage increase or decrease in the multiple of the return of the Fund’s underlying index due to the compounding effect of losses and gains on the returns of the Fund...
It also expected that the Fund’s use of leverage “will cause the fund to underperform the compounded return of three times its benchmark in a trendless or flat market...At higher ranges of volatility, there is a chance of a near complete loss of value if the Index is flat.”
Regulators, including FINRA, have recently voiced concerns with these leveraged instruments. A number of firms, including UBS and Morgan Stanley, have suspended or placed restrictions on the purchase of these funds, saying that the products inherent short term nature is not consistent with the firm’s long-term view of investing.
If only more financial advisors could do a better job educating the retail investor on these risks, along with greater transparency and warnings from ETF providers about the very narrow intended purpose of these funds.
It seems best that retail investors keep their ETF portfolios simple and inform themselves fully on what they are getting into.
Such knowledge is important to make the decisions consistent with their investment goals. After all, most unleveraged products can offer broad diversification, transparency, liquidity, and accurately track their respected indexes.
For those investors still looking at leveraged ETFs, use caution and only let the professionals trade these gimmicky products.
John Balassi is a senior IFR analyst