ETF Basics
Exchange-traded funds (ETFs) are an emerging class of low-cost index funds that trade like stocks. They can be bought and sold throughout the market day, and they offer portfolio exposure to the world’s leading indexes.
Why ETFs?
For investors and leading financial advisors, exchange-traded funds have become a popular choice for numerous reasons. Here is a brief review of some key advantages:
- Lower Expense Ratios – The expense ratios of ETFs are consistently lower than actively managed mutual funds. Lower costs without sacrificing quality are a key attraction.
- Tax Efficiency – ETFs are renowned for their low portfolio turnover. For shareholders, this can translate into lower tax liabilities.
- Trading Flexibility – ETFs trade throughout the market day and can be bought and sold at the click of a button. ETFs also allow the investor to use order types such as limit orders and trailing stop orders to take advantage of price movements.
- Tactical Investment Strategies – ETFs open a universe of sophisticated investment strategies such as covered call writing, cash management, hedging, tax-loss re-positioning and core/satellite.
Why Not ETFs?
As with any investment, there may be distinct disadvantages to investing in ETFs:
- Leverage – Some recent ETFs involve the use of leverage. In this situation, leverage means investing with borrowed money. Great care must be used when investing in any leveraged investment because leverage magnifies gains and losses and can substantially increase an investor’s risk.
- Concentration – Some ETFs have a high concentration in just a few underlying assets. There may be no reason to pay an investment firm a yearly fee if you could easily invest in the underlying assets yourself for less money.
- Homogeneity – High concentration also can result in a lack of diversification in your portfolio. It’s important to understand the asset allocation of an ETF before investing in it to ensure you’re achieving your desired level of diversification.
- Options – ETFs have the unique position of having option contracts. While you may find options to be a good fit as an investment or risk management tool, the risks associated with options mean their use might not right for everyone. Options involve special risks that may expose you to potentially rapid and substantial losses. When considering the use of options, you should determine how it fits your own investment philosophy and fully understand the rules and requirements.
Advanced ETF Strategies:
The unique structure of exchange-traded funds makes sophisticated investment techniques possible.
Core/Satellite
This strategy is a blend of index and active investing. Index investments, such as ETFs, become the foundation of the portfolio’s construction, and actively managed investments are added as satellite positions. With this approach, investors index their core holdings to more efficient asset classes and limit their selection to active managers that deliver consistent alpha or outperformance for other categories. Today, most large pension plans use a core/satellite approach in their investment policy and many investors are beginning to do the same.
Diversification
ETFs are effective diversification tools for managing risk. For example, investors can guard against over-concentrated equity positions by using ETFs as single stock substitutes. This hedging technique can reduce risk and volatility by letting stockholders diversify away from large equity positions in the companies they own or at which they work. Investors should be cautious, though, as some ETFs may be concentrated heavily in just a few stocks or a volatile industry and may not provide the level of diversification expected.
Leverage
Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by FINRA (Financial Industry Regulatory Authority) and by individual brokerage firms. While margin investing can be profitable for investors who are correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns even beyond the amount deposited.
Options
ETF investors have a multiplicity of option strategies at their disposal. Purchasing call or put options is an aggressive technique. An options investor can control a large number of ETF shares by paying a premium for an option on the ETF. The premium price is a fraction of what it would cost to purchase the shares in the open market. This provides an options investor with a great deal of leverage and a high risk/reward opportunity.
A more defensive approach uses put options in conjunction with portfolio holdings. Buying protective puts on ETF positions would insure a portfolio against declining prices. There are many other tactical possibilities with options.
Shorting
ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation of the price of an ETF declining in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. Shorting is an advanced technique and involves substantial risk.
Sector Rotation
Convenient market exposure to various industry sectors is readily obtained with ETFs. By tactically shifting assets, investors can over and underweight specific sectors according to their financial research, economic outlook or market objective. Owning or selling concentrated business segments allows ETF investors to capitalize on both positive and negative sector trends.
Leveraged ETFs
Two variations of exchange-traded funds (ETFs) are leveraged ETFs and their counterpart, inverse ETFs.
Like most ETFs, leveraged ETFs are funds that are listed and traded like stocks and are designed to match the performance of a particular index. But, there are two distinct differences:
1. Leveraged ETFs magnify exposure to an index. While a regular ETF will attempt to match the benchmark index’s performance 1:1, a leveraged ETF will usually match it 2:1 or 3:1. That means for each $1 you have invested, you have $2 or $3 of exposure to the index, magnifying your potential risk and volatility by 200% or 300%. This additional exposure comes from derivative investments. Leveraged ETFs will often have a significant percentage of their holdings in futures and swaps, and the funds are compounded daily.
2. Leveraged ETFs have daily investment objectives. A leveraged ETF might meet its goal of performing at 200% of the benchmark on each individual trading day, but over time, the fund’s performance in relation to the benchmark will likely be significantly different due to the effects of compounding. Some ETF fund managers strongly recommend that investors only invest in these funds if they plan to monitor the fund daily and adjust their investment as needed to meet their investment goals.
Inverse ETFs have the same daily goals and magnified exposure as leveraged ETFs, but they aim to perform opposite their benchmark index. For example, if an index goes up 1%, a corresponding 2:1 leveraged ETF would go up 2%, and a 2:1 inverse ETF would go down 2%.
Understanding why leveraged ETFs do not maintain their 2:1 or 3:1 performance relative to the benchmark index over time is key to understanding the risk involved in these investments. Take, for example, a $100 investment in a traditional ETF, an equal investment in a 2:1 leveraged ETF and another $100 in the corresponding inverse ETF:
|
Day |
Index |
Traditional ETF |
Leveraged ETF |
Inverse ETF |
|
1 |
0 |
$100.00 |
$100.00 |
$100.00 |
|
2 |
5% |
$105.35 |
$110.70 |
$89.30 |
|
3 |
-6% |
$99.03 |
$97.42 |
$100.02 |
|
4 |
-10% |
$89.13 |
$77.93 |
$120.02 |
|
5 |
10% |
$98.04 |
$93.52 |
$96.02 |
|
6 |
6% |
$104.12 |
$105.12 |
$84.11 |
|
7 |
-4% |
$100.00 |
$96.81 |
$90.75 |
|
$0.00 |
-$3.19 |
-$9.25 |
In the hypothetical example above, the traditional ETF that follows the benchmark index ended the seven trading days back at $100.00, breaking even. The leveraged ETF lost more than 3% of the original investment, while the inverse ETF lost nearly 10% of the original $100.
Because of the magnified exposure to the benchmark index, the volatility is magnified in the leveraged funds, and we see stronger up and down swings. And because the percentage movement up or down is affected by compounding, meaning it is based off of the final price from the previous day, it is harder for the leveraged funds to recoup their losses.
As a relatively new investment product, leveraged ETFs provide the investment community a learning opportunity to determine whether these investment vehicles are best suited for short-term, mid-term or long-term investing. Analysts point out that, as in our example above, often the daily movements can be more profitable than multi-day returns, but this type of performance is not guaranteed. Investors should evaluate their personal investment strategy and risk tolerance before deciding whether leveraged or inverse ETFs are the right choice for them.
