Tag Archives | ETFs

The Pitfalls of Nontraditional ETFs

The following are notes from comments I recently gave on the pitfalls of investing in nontraditional ETFs.

The regulators would be wise to keep an eye on non-traditional ETFs. The original ETF structure was something that should be celebrated. It added a new level of liquidity and tax efficiency and lowered trading costs for investors who would have normally used mutual funds as their default investment vehicle. There is little not to like.

Unfortunately, the same cannot be said for some of the more exotic issues of late. I was just discussing Master Limited Partnership (MLP) ETFs and ETNs and the drawbacks of both. In the case of the ETN, JP Morgan runs a very popular option that trades under the ticker symbol $AMJ. Unlike ETFs, which hold the underlying shares of the companies they track in trust, an ETN is not much more than a bond. JP Morgan promises to pay investors a return equal to the return of the MLP index.

This is not a deal breaker, and I myself hold shares of AMJ for clients. But many of the people buying this security are completely unaware that it is not really backed by anything other than the full faith and credit of JPMorgan. And after the 2008 meltdown, that means less than it used to.  (As a secondary issue, the distributions from AMJ are taxed at a much higher rate than on the MLPs its tracks.  This isn’t an issue in an IRA account, but it is a major irritant for a taxable investor.)

The popular Alerian MLP ETF, which trades under the ticker $AMLP, is a true ETF in the sense that it holds shares of its underlying positions like a traditional ETF. But because of the accounting issues with MLPs, AMLP has an enormous hidden fee in the form of a “deferred tax liability.” I’ll spare you the details of what that actually means, but suffice it to say, the much-heralded tax benefits of traditional ETFs do not apply here.

Commodity ETFs and ETNs are also particularly problematic because, with few exceptions, they tend to use futures rather than physical commodities. (The popular $GLD is an exception; it holds physical gold in a vault.) There is nothing inherently wrong with futures for investors and traders that understand them. But most people buying, say, the oil ETF $USO, have no idea that they value of the fund erodes every month due to contango (i.e. negative roll yield). Contango is an issue that could warrant an entirely separate article, but I’ll summarize it like this: due to excessive passive investor (i.e. ETFs, mutual funds, etc.) interest in the front month contract, the price of the contract gets pushed up above the spot price. As the contract approaches maturity, its value falls to match the spot price.

Think of it like this: rather than buying low and selling high, the ETFs are perpetually buying high and selling low. This is why so many of them have underperformed the commodities they are supposed to be tracking. Frankly, it borders on criminal negligence.

A good manager knows how to mitigate or avoid these risks. This is one of those times where paying a professional manager with expertise in the area you are looking to invest in will generally make more sense than going the passive index/ETF route.

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Charles Sizemore Discusses Actively-Managed ETFs

Charles Sizemore gave his thoughts on actively-managed ETFs to Jane Wollman Rusoff in the October issue of Research Magazine.  Here are a few highlights from the article:

That new kid on the block with the monogram “ETF” isn’t just passing through town — the exchange-traded fund is here to stay. And what’s been hyped for three years as the next big thing in the hot ETF market, actively managed ETFs, may soon spark major change… Alongside the immensely popular passive ETFs that track indexes, there are currently trading at least 36 active ETFs, whose managers seek to outperform the indexes…

In a perfect world, passive and active ETFs will coexist. “There’s room for both,” says Charles Sizemore of Sizemore Capital Management, in Dallas, and editor of The Sizemore Investment Letter. “If you find a good manager, an active ETF can definitely add a couple of points to your return every year. But there will be times when passive index exposure — in bonds or stocks — is exactly what you want.”

But as efficient as ETFs are, if invested with imprudence or using inappropriate funds, the vehicle can backfire.

“An ETF is like a gun — in the right hands, it can be used effectively and efficiently. In the wrong hands, it can be deadly and lead to financial destruction,” Sizemore says. ETFs’ famed liquidity is double-edged. “The flip side to being able to get in and out of the market quickly is the tendency to overtrade, and that’s one of the biggest detriments to long-term investing success. Financial advisors get lured into it, and they do so at their own risk.”

Sizemore considers leveraged ETFs “more of a gambling tool that encourage Mom and Pop investors to take risks they can’t afford.”

Mostly, there’s plenty to cheer about in the ETF space; for example, the availability of emerging markets’ sector funds.

“They enable you to invest in emerging markets and also cherry-pick the sector you want to get into. So, for example, you can get direct exposure to emerging markets’ consumers,” says Sizemore. “Emerging Global Shares has a suite of ETFs that includes an emerging markets’ consumer ETF ($ECON).”

Though providers continue to bring out an endless parade of new ETFs, some may be suitable only for short-term trades: that is, if narrowly focused, they might be thinly traded and have little chance of longevity.

Sizemore once invested in a luxury goods ETF but, never attracting enough assets, the fund closed.  In 2009, Stevens launched a family of faith-based ETFs — for the five largest Christian denominations in the U.S. — but FaithShares is now defunct too. “Not enough assets were gathered to make it profitable,” he says.

To read the article in its entirety, please see “The New Wave of Active ETFs.”

 

 

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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