Today I am pondering exactly how some of these handy little ETFs I like to trade actually work. For those of you not exactly in the finance game, an ETF is an Exchange Traded Fund. You can get a good primer on it in wikipedia: http://en.wikipedia.org/wiki/Exchange-traded_fund
My investigation has actually left me a little skeptical and nervous. I find them to be good trading vehicles to take advantage of market movements where I would never have the ability to trade nor the tolerance for risk to directly invest in. But, I do not think most of them are a good long term investment strategy.
The best way for me to hash this out is to make a pro and con list. First I will start with the positives:
+ A much safer way to short an index or just about anything. Compared to actually shorting an equity where you could end up owing mountains of money, the worst that can happen owning a ETF is it goes to zero.
+ Allows you to get a broader exposure to markets with a smaller investment.
+ Can be bought and sold in 15 second increments. Much better than a mutual fund. Mutual Funds only trade at the end of the day.
+ Their operating expenses are lower than most mutual funds and are alot cheaper than trying to buy and sell all 500 stocks in the S&P by yourself.
+ You can utilize leverage against just the movement of an index.
Now the negatives (these answers will be longer because this is what I am trying to figure out):
- Arbitrage is risky. Especially when it is done on large scales. Just think of the crash in 1998 and what happened to Long Term Capital Management(LTCM). In September 1998 they lost $4.6 Billion in arbitrage gone horribly wrong. I know that arbitrage is one of the great ways that ETFs stay in check and return to fair prices, but, with so many ETFs out there, this has to expose risk to other arbitrageurs going after the same piece of the action. This would mean that the faster computers are going to win each time. Thus, if you get on an ETF that doesn't have the edge, you could potentially get hosed on one of those transactions.
- ETFs are exempted from the Investment Company Act of 1940. This makes them very similar to a hedge fund in that they can use derivatives. That is a short path till you get into Credit Default Swaps and Credit Default Options which we have heard enough horror stories over the last few months to see how risky these can become. AIG needing $85Billion to just not go under, $7.2Billion at SocGen for futures mis-use... the list goes on and on...
- Volatility can be a real bitch on the long term performance of an ETF. If volatility of the market is high (think the VIX) then the deviation of the performance of the ETF from the index it is tracking will be greater.
- The whole bubble aspect. Whenever this much money moves into one place, eventually something will cause the bubble to pop. It can't go up forever. By the middle of 2008 there were 680 ETFs in the US with $610Billion in assets. Something will eventually have to give.
- And then the last one which is the foundation of why I think ETFs are good short term trades but leveraged ETFs, in particular, are terrible long term investments is because: These leveraged funds are designed to give a positive or negative multiple of an index on a daily basis and NOT for greater periods of time. Thus, the fund will not return a simple multiple of an index's return for much longer than periods of one day. This is the reason why so many of the short oil ETFs did not track along with the plunge in crude last year.
So, as much as I love my SDS (ProShares Ultra Short S&P 500)... I doubt I could ever bring myself to hold on to it for more than a few days at a time. No matter how bad the market looks for the next month, quarter, year, decade.
I will end with the great observation from Fast Money trader Jeff Macke: They’re not for buy and hold. ETFs such as the SDS are like dating a stripper, he says. “It’s fun but it’s not going to end well.”
I think that pretty much sums it up.
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