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How to Safely Navigate Through Crowded ETF Waters

by David Fry

I once interviewed a successful exchange-traded fund (ETF) sponsor and had the temerity to offer some suggestions where some ETFs were needed.

The response from this person was: “Look, we’re not interested in filling needs as much as we are in building a business.” This made an important point: Investors must align their investments to match their needs versus the business interests of sponsors.

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David Fry is founder & publisher of ETF Digest and author of “Create Your Own ETF Hedge Fund: A Do-It-Yourself ETF Strategy for Private Wealth Management” (Wiley Finance, 2008).
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The market for exchange-traded funds has never been more robust and expansionary. The most prominent activity for sponsors is similar to a game of Battleship in which the winner fills all the slots before the next guy. Why? Because the “first mover advantage” to a sector and index cements their brand as “the go-to shop.”

The most important activity for investors remains focusing on those ETFs that work and matter to them versus any sponsor’s marketing campaign.

It’s hard to imagine that in 2005 we published an essay in our newsletter, the ETF Digest, entitled “The ETF Tsunami” that discussed the then-impending flood of new ETF issues about to hit the markets. Obviously, it seemed even then the sector was undergoing explosive growth, but with today’s level of issuance “tsunami” seems an understatement.

Then we noted roughly 200 exchange-traded funds. Now, in 2010, there are nearly 1,000 exchange-traded funds. Asset class coverage has also rapidly expanded from just a few stock- and bond-oriented funds to currency, commodity, actively managed, inverse, long/short strategies, options-related, preferred, leveraged long or short issues and so forth. In short, there’s not an asset class that isn’t being traded or not in registration.

Further, ETFs are also gaining acceptance internationally and expanding rapidly. There are hundreds of listings in just about every established market in Europe, Asia-Pacific and even Latin America.

Nearly $1 Trillion Invested

The number of players or sponsors in the ETF game is growing. Even brokers like Charles Schwab are launching their own ETF products and Fidelity is in a partnership with BlackRock’s iShares. Exchange-traded funds in registration with the Securities and Exchange Commission (SEC) number in the many hundreds with long backlogs. ETF issues in the U.S. alone are pushing one thousand with assets under management soon to top $1 trillion.

Traditional mutual fund companies are challenged to enter the ETF market, fearing cannibalization of existing products. Nevertheless, many can’t ignore the trend and have entered the business. Amvescap (Invesco) purchased PowerShares and mutual fund giant Vanguard features a large ETF product line.

Being First Has Its Advantages

The way the battle works on the ETF seas is to be the first issuer to cover a sector before the other issuer.

Gold is a great example. State Street was the first out of the gate with SPDR Gold Trust (GLD) in 2004. It now has over $50 billion in assets under management. Just a few months later, in early 2005, iShares launched COMEX Gold Trust (IAU) with assets under management of around $3.8 billion. Forgetting the structural differences, this is the most prominent example of the Battleship game. IAU’s later launch doomed it to second fiddle status even though $3.8 billion in assets is nothing to sneeze at. To fight back and gain more market share, iShares has cut the fee on IAU and declared a high stock (split 10:1) dividend.

The scramble by ETF issuers is still in high gear. With many issues in registration with the SEC there is incredible business pressure to come to market first with similar offerings.

Such competition is good for investors since it yields more favorable terms to them. When looking at exchange-traded funds linked to the same index, consider the fund with the lowest fees.

ETNs versus ETFs

Exchange-traded notes (ETNs) notes are popular given the easier registration and issuing process versus exchange-traded funds (ETFs). Most ETNs are senior debt of the issuer/sponsor. Popular issues include commodity and currency issues from iPath (Barclays) and PowerShares (Deutsche Bank). The risk to investors remains the credit-worthiness of the guarantor. The reward is that popular sectors become more quickly available.

Commodity tracking funds that include a wide variety of sectors (energy, metals, agricultural and so forth) were launched first a few years ago by Deutsche Bank as ETNs, which are guaranteed by Deutsche Bank as to the integrity of assets in the fund. Examples include DB Commodity Long ETN (DPU), DB Base Metals Short ETN (BOS), DB Agriculture Double Long ETN (DAG) and so forth. They have now partnered with Invesco PowerShares for marketing purposes but still manage the funds in New York City.

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More recently, iPath, a part of Barclays Bank with senior notes guaranteed, has joined in issuing ETNs on copper (JJC), grains (JJG), currency (ERO, GBB, and JYN), energy (OIL) and so forth.

Rydex was first in issuing unleveraged currency issues for U.S. investors, and we’ve been using them for quite some time.

Remember, with those issues deemed as “leveraged,” most basic commodity and currency issues aren’t leveraged. When someone asserts that dealing in these funds is risky, I always respond, “Given their structure, they may not be risky enough so as to earn decent returns, especially in currency issues.”

ETPs That Fail

Exchange-traded products (ETPs) include both exchange-traded funds and newer and more easily issued exchange-traded notes (ETNs); see the box above for more on ETNs. In 2010, there are 300 ETPs with $20 million or less in assets under management. Some of this may be due to newness of the issue as assets are growing. On the other hand, investors should be wary of issues that may be in decline and in danger of being closed or merged with another fund. ETPs that have closed or merged within the past few years have included funds offered by Northern Trust, Claymore Securities, WisdomTree, MacroShares and Grail Advisors, to name a few.

Once again, this issue goes right back to the business interests of sponsors versus investors. As an investor, you should monitor current total assets (assets under management, or AUM) of any exchange-traded product you’re considering as an investment or currently own. I consider $25 million to be the threshold for most exchange-traded funds unless it’s a new issue linked to a popular existing index. iShares MSCI New Zealand Investable Market Index Fund (ENZL), which was recently issued, has a ways to go to get to $25 million, yet the major indexes I’ve been following for many years track this ETF well. Thus, there are considerations besides just the dollar amount. Such considerations may also apply to commodity and currency sectors where no current exchange-traded fund exists, but the linkage to an existing index with a long history overrides concerns about assets under management.

Individual investors are advised to always separate their investment interests from the business interests of issuers. Remember what an issuer CEO told me straight out: “We’re not interested in filling needs as much as building a business.” This must always be foremost in your thinking as you evaluate new or existing ETF issues.

What’s That Index Again?

Exchange-traded funds, as indicated previously, are linked to indexes. Most mature ETFs are linked to indexes we know fairly well: S&P 500, NASDAQ 100, S&P MidCap 400, S&P SmallCap 600, Barclays Treasury, and so forth. All these linked securities are widely traded, track their underlying indexes well and are trusted by the public.

In an effort to gain an edge, perhaps as new entrants to the industry are increasingly relying on new indexes, some sponsors are creating indexes out of thin air, while others are employing so-called quantitative strategies. The latter generally can be found with PowerShares and a few other firms. These indexes generally utilize recognizable quasi-active methodologies, which might take a conventional index and reweight and rebalance it according to dividends, earnings momentum, price-to-book ratio, price-to-sales ratio and so forth. Some of these work well, but you should have a good understanding of the strategies used.

Another problem with some new indexes is obtaining historical data. Much of what you can get and analyze is comprised of backtesting what the index might have done had it existed previously. This methodology, depending on how exotic the base is, can be misleading since there’s no guarantee that advertised results would have been realized.

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Examples of this include the new emerging markets ETFs that were just launched by Global X Shares. There is little in the way of historical data for the indexes that these funds are based on. This includes the Global X Brazil Consumer ETF (BRAQ), where historical data would be difficult to find since many of the companies in the index didn’t exist until recently. Further, if they had existed earlier, they would have been lightly traded or perhaps completely differently structured companies. If you, like me, believe in the positive demographics of a young emerging Brazil consumer, then you will have to go with your fundamental beliefs and take a leap of faith in the construction of the index.

Fees Matter

You only need to remember one thing regarding ETF fees: The further away from the mainstream of major market indexes you wander, the higher the management fee. Therefore, exchange-traded funds like the SPDR S&P 500 (SPY) will carry a very low annual fee of 0.10%, whereas funds covering more exotic sectors can have fees as high as 1%.

The higher fees are generally in more aggressive or exotic sectors. Alternative sectors like commodities and currencies generally have higher fees, as do leveraged issues. If these sectors perform properly and your timing judgment is correct, the rewards are much greater, but so are the risks. Buy and hold investors should logically concentrate on lower fees where possible.

Actively Managed ETFs

An actively managed ETF is just a mutual fund masquerading as an exchange-traded fund. After all, one of the beneficial characteristics of an ETF is its linkage to an index that is trackable and transparent. Issuers are still wrestling with effective ways to allow investors to track what managers are doing intraday. However, many managers don’t want others to see what they’re doing intraday for competitive reasons (and perhaps other reasons, like vanity and embarrassment). If you know the fund manager and believe in what they’re doing, enter with your eyes wide open.

Inverse ETFs

ProShares led the way in 2006 offering investors to short an unleveraged S&P 500 index using the inverse ProShares Short S&P 500 ETF (SH). This was matched by other unleveraged issues during or shortly after this period on well-known indexes, like technology.

The primary purpose and benefit of inverse ETFs are that these funds allow investors to hedge their market exposure should stocks tumble. It is a more convenient way for individual investors to accomplish this without using options or futures.

Given the fund’s structure to achieve the inverse performance of the daily movement of the S&P 500 or any other index, tracking can vary during periods of high volatility. Investors should be aware of this and rebalance their exposure possibly quarterly to adjust. Further tracking inefficiencies are possibly no worse than the deterioration in options prices as a contract moves closer to maturity, given the complexities of incorporating those strategies. (An options contract expires worthless if it is not exercised prior to its maturity.)

Leveraged ETFs

I’m a fan of leveraged ETFs, and am glad ProShares, Direxion, Rydex and PowerShares (via Deutsche Bank) have made these available. But like any other security or product, these issues need to be used properly. When used correctly, they allow individual investors and advisors the opportunity to hedge or add more potential return to index-based securities.

A leveraged ETF is a fund whose total futures contracts value exceeds the amount required to fulfill its unleveraged objective. It should be used strategically and tactically by experienced investors over short periods of time. This may include day trading and time periods of just a few weeks. To accomplish performance goals and achieve success, a disciplined and systematic approach is essential.

The introduction of commodity and currency market ETF products has given investors the opportunity to participate in markets previously unavailable to them. Trends in these market sectors can change quickly, and participating successfully in them therefore requires the careful application of trading methodologies. That’s what the most sophisticated investors in this sector do—they trade.

Unleveraged inverse ETF products are a blessing to those investors hoping to avoid big losses due to the occasional but devastating bear market, such as we’ve recently experienced. These funds don’t have the large tracking errors ascribed to the entire product group.

Leveraged and unleveraged inverse ETF products allow sophisticated individual investors the ability to construct hedge fund–like strategies used by advisors and money managers that were heretofore unavailable to individual investors. ETF products exist to protect investors from the carnage of bear markets and to provide opportunity to profit in bull markets.

Creating ETF Portfolios

Here are two of the many strategies and portfolios that the ETF Digest employs to help fill the needs of a variety of investor profiles.

Lazy Portfolio

If you’re an investor who doesn’t wish to do much trading, then there exist many exchange-traded fund opportunities to structure and assemble a diversified portfolio. These may include ETFs and ETNs in conventional equity sectors, international developed and emerging markets, domestic and international fixed-income markets, and alternative investments including currency and commodity sectors.

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Portfolios may be structured to suit the needs of conservative, income-oriented, balanced or more aggressive investors. Rebalancing may occur semiannually or as frequently as suits the investor. We generally rebalance semiannually but an annual rebalance is perfectly appropriate, especially if taxes are a consideration.

Where possible, utilize funds that have the most inexpensive management fees. Given that alternative markets (currency and commodity) generally have higher fees, investors have to accept those costs to be involved.

Moderately Traded Portfolios

At the ETF Digest, we maintain three actively managed model portfolios. Two approach markets from a technical view but are arranged based on fundamental views of sector exposure. Technically, these portfolios utilize weekly charts which would, when successful, feature trading from an intermediate few—thus eliminating frenetic activity. When not successful, we sell—and such changes could be abrupt.

Portfolios are arranged in a manner similar to a hedge fund structure akin to global macro long/short. Portfolio constituents are fixed, but may change annually to keep up with fundamental global economic views and new ETF issues more suitable to the goals.

Unleveraged inverse ETF issues may be utilized as speculative investments over an intermediate term when appropriate. If warranted, these may be paired with long positions in other ETF sectors. Occasionally, when trading ranges are dominant, we don’t hesitate in maintaining high cash balances that can last an indeterminate period. Sometimes it’s best to sit things out until trends become clearer. Again, having the expanse and variety of ETF issues makes this type of activity possible where it wasn’t just a decade ago.

In sum, trading is active and frenetic, risks are high and taxes may negatively affect overall performance given short-term results. When these strategies are successful, performance can be substantially increased—or, the more the risk the higher the potential results and losses.

Conclusion

We’re happy with the tsunami of exchange-traded funds on or about to enter markets, since among the tailings we’ll find nuggets to suit all the previously described strategies.

With the onslaught of new issues and many issuers anxious to enter the sector, there will be failures. Poorly conceived, marketed or supported exchange-traded funds have folded or merged with other existing products. Some strategies just don’t work and we’ve seen failure with some commodity ETFs where the issuer wasn’t capable of dealing with the unique aspects or quirks related to futures markets. Failures will continue.

The good news is that the heavy issuance of exchange-traded funds creates opportunities for investors that heretofore never existed. The bad news is that investors will have to work harder to separate the wheat (issuer’s interests) from the chaff (investor’s interest).

David Fry is founder & publisher of ETF Digest and author of “Create Your Own ETF Hedge Fund: A Do-It-Yourself ETF Strategy for Private Wealth Management” (Wiley Finance, 2008).


Discussion

Dan from FL posted over 4 years ago:

I am a new member, I have seen very little discussion concerning the NUVEEN ETFs. Is there any past or pressent discussinos about this group of funds?


Patt from MD posted over 4 years ago:

I am an older person with investments in Vanguard and Fidelity. My effort is to transfer some of these to ETFs.I have yet
to find which ETFs will fulfill my need.


Curt from FL posted over 3 years ago:

Why would I comment on general data with little specificality!


Jerald from VA posted over 3 years ago:

Good question, Curt. Why indeed comment at all?

Pat. Vanguard has a great selection of ETF's you can buy through their brokerage house at no commission. I use them to support the Wellington (balanced) and the Precious Metals managed mutual funds. They include; Heath Care ETF, Emerging Markets, EuroPacific, domestic and world REITs, Energy and Dividend Appreciation.
I do feel a downturn in all these holdings is more than possible but decided against using a ETF to short. We have no choice but to face the music. I do hold a few individual stocks, but less than 10 percent of portfolio. I believe ETF and mutual funds are the way to go for most of us.


Wayne Barbarick from CA posted over 2 years ago:

Good article on ETF's. I am invested in gold and silver ETF's(about 15% of my portfolio) and they follow the gold & silver market prices very closly. My investment has grown by 75% over 3 years. I use these ETF's as a hedge against inflation and the Federal Reserve's printing of money.


Charles from CA posted over 2 years ago:

Generalities are difficult to comment upon specifically.


Nicholas from FL posted 3 months ago:

Generic article -fine for new bees


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