Now It’s All About ETF’s.

Exchange traded funds (ETF’s) could soon replace traditional mutual funds as the primary investment vehicle for individuals because of the huge cost, tax, and liquidity advantages they offer. That’s the learned opinion of my friend, Tom Lyden, who runs a site dedicated to this versatile security.

Tom’s site offers updates on new ETF launches, research tools, and a free newsletter presenting a half dozen investment ideas a day. He finds ETF’s so attractive that he has converted his own management practice for high net worth individuals at www.globaltrend.com from one focused on mutual funds, to an ETF orientation.

ETF’s enable rifle shots at specific, countries, industries, currencies and commodities on the cheap without having to wade through a morass of complicated settlement details. You can buy ETF’s on 50% margin, go short, and with the larger ones, like the S&P 500 (SPY), deal with only a penny spread, plus a token commission.

 

 

The ETF industry has exploded this year, and there are over 1,440 such instruments issued by 49 providers with a total market capitalization of over $1.3 trillion. The bigger ETF’s are now resorting to swaps to sidestep CFTC position limits on options and futures contracts. Since most of the current ETF’s mimic indexes, daily buying and selling is minimized, creating fewer taxable events for American investors. Low turnover also helps keep operating expenses down.

These quasi index funds confined to narrow groups of stocks can offer better liquidity than any single security. They no doubt have also played a major role in the decline of trading volumes across all US exchanges.

However, ETF’s still have some limitations. Many brokers and custodians don’t permit inverse, short, or leveraged ETF’s to go into 401k’s. This has made it difficult for some of my readers to follow my Trade Alerts to the letter. The explanation is that these funds, which offer 200% and 300% long and short exposure, are illiquid, have a heavy cost of carry, and can diverge substantially from their underlying markets. Better to use these as day trading vehicles for taxable accounts only, if you get involved at all.

Other strategies generating debate are funds of funds holding ETF’s with much higher cost structures, and actively managed ETF’s, which cede their index qualities, for better or for worse. If you look at the number of ETF’s closed this year, about 300, a disproportionate number were single manager ETF’s that see liquidity dry up to nothing. A few hedge fund ETF’s have already made their debut, like the Advisor Shares Active Bear Fund (HDGE), which offers traders a portfolio of short positions in stocks with terrible fundamentals.

 

 

One big glaring shortfall of ETF’s has been their tracking error against the underlying product they represent. The prizewinner here is the United States Natural Gas Fund (UNG), which has cratered 99% from $500 to $10, compared to  a mere 87% decline in the price of natural gas itself. During one three month period, a few years ago, I watched this fund fall 40% while natural gas rose by 40%, and this was for a long only fund!

The divergence is caused by the contango in the futures market, whereby far month contracts trade at large premiums to front month ones. This is caused by a multi year glut of gas on the market unlocked by the new fracking process, which is forcing producers to pay big premiums for storage. An entire sub industry of hedge funds has risen up to take advantage of this trade. I often hear from them, and they talk about 100% plus annual returns made at the expense of (UNG) investors. This is why I only play (UNG), and its cousin, the United States Oil Fund (USO), from the short side.

You should not plunge in and buy an ETF just because you saw the ticker symbol on TV. Avoid ones that trade less than 25,000 shares a day and have less than $50 million in assets. That is about half of all the ETF’s out there. Their managers are probably losing money and may close the fund. While they bill themselves as “low cost” many aren’t. I have seen expense ratios as high as 3%, so it is prudent to go to their website first and get the real dope.

Dealing spreads can be huge in some of the less illiquid ones, and worse in the underlying options. And remember, liquidity is a thing that ebbs and flows. Also, avoid funds that have too much concentration in a single stock. It’s cheaper just to buy the stock. Look no further than (QQQ), which until recently, had a 20% weighting in Apple (AAPL).

 

 

ETF’s are much more attractive than mutual fund competitors, with their notoriously bloated expenses and spendthrift marketing costs. You can’t miss those glitzy, overproduced, big budget ads on TV for a multitude of mutual fund families. You know, the ones with the senior couple holding hands, walking down the beach into the sunset, the raging bulls, etc. You are the sucker who is paying for these. Sometimes I confuse them for Viagra commercials.

I once conducted a comprehensive audit on a mutual fund, and I’ll tell you, Dr. Stephen Hawking never saw a blacker hole. There were so many conflicts of interest, it would have done Bernie Madoff proud. Any trainee assistant trader can tell you that more than 90% of all mutual fund managers reliably underperform the indexes, some grotesquely so.  Moving in and out of positions can cost an absolute fortune. Published performance is bogus; they show a huge survivor bias, not including the hundreds of mutual funds that close each year. And there’s always that surprise tax bill at the end of the year.

If there was ever an industry crying out for restructuring, consolidation, and price competition, and ultimately a whopping great downsizing, it is the US mutual fund industry. ETF’s may be the accelerant that ignited this epochal sea change, with the number of mutual funds recently having shrunk from 10,000 to 8,000. We lost 1,334 during the 2009 crash alone. It’s still early days, with ETF’s only accounting for 6-7% of trading volume, even though they have been around for a decade.

 

Bloated Expenses Are Coming Home to Haunt the Mutual Funds

I have to admit that when the first ETF came out in 1994, State Street’s launch of the SPDR S&P 500 (SPY), I thought it was just another Wall Street scam. Today, (SPY) the fund boasts a gargantuan $110 billion in assets, some 9% of the ETF total.

Then, in 1996, Morgan Stanley made the product respectable by introducing 17 foreign-based ETF’s pegged to its famous international indexes. Here was real added value. Instead of flying off to some foreign country with undrinkable water and opening up an account at a dubious broker denominated in strange foreign currencies, you could simply buy the ETF on a US exchange. The cost savings were huge, and the ease of execution brought thousands of individual investors into the international arena at just the right time.

Sensing there was a new gravy train, many other issuers rushed to bring out new ETF’s of their own. That led to the unfortunate and ill-timed float of the technology based NASDAQ 100 Trust (QQQ), just before the absolute peak of the dotcom boom. Suddenly, ETF’s were back in the doghouse as billions of dollars were lost. Four years in the wilderness followed as the fund plunged from $100 to $19.

 

 

In 2004, Street Tracks introduced the first gold ETF, which later became known as the (GLD). Here was more added value. Trading in physical gold and coins can be hugely expensive, and this industry is rife with fraud as well. Professionals sidestepped these costs since the seventies by dealing in the futures markets for the barbarous relic, which most individuals are not set up to handle.

The timing of the launch was propitious, as it came at the beginning of what I believed was a decade long run into global hard assets. I jumped in with both feet. The chart that followed is one of the most attractive ones that you will ever see. Today, the (GLD) is the second largest ETF out there, with $74.8 billion in assets. It has become the largest short-term driver of the price of the yellow metal. Later offerings of ETF’s for silver (SLV), platinum (PPLT), and palladium (PALL), gave investors easy entry to more obscure, difficult to trade, precious metals which became great investments.

 

Thank goodness for the ETF industry that they never got involved with subprime loans or the more egregious real estate offerings that were made in the run of to the 2007 asset bubble top. The instruments were just too illiquid and obscure to create a liquid, public vehicle.

When the collapse came, ETF’s provided better-educated investors the means to hedge their downside risks for the first time. After that, there were only two classes of individual investors: smiling, well-funded, secure ones who hedged, and suicidal, depressed, and broke ones who didn’t. This was when I launched the Diary of a Mad Hedge Fund Trader newsletter, so the timing couldn’t be more perfect for me.

During the flash 2010 crash, when the Dow crashed 1,000 points in minutes, ETF’s did not exactly shine with brilliance. Lack of liquidity forced many to drop by half in value, or to zero, in seconds. You can still see these spikes on the yearly charts. While many of these trades were later cancelled after much litigation, many weren’t. What this event did do was to render stop loss orders on ETF’s useless. The risk is that you get a confirm that night saying that your position was sold yesterday for nothing. I’d rather spend my free time at home in bed watching Homeland than wasting time speaking to lawyers in order to chase crooked brokers.

 

What does the future hold for ETF’s? They have attracted $100 billion a year in new cash for the past six years, and this growth rate looks set to continue. Bond ETF’s will be a major growth area as investors seek the safe haven of steady interest payments in these uncertain times. Earlier this year, bond giant PIMCO launched its Total Return ETF (BOND), which has attracted $3.8 billion in assets. It has gone virtually straight up in value since its March launch, thanks to never ending quantitative easing from the Federal Reserve.

You can also expect more independent advisors, like my friend Tom above, to vacate captive families of mutual funds and move into more active ETF management. You can expect tax reforms to make it easier to shift more money out of mutual funds and into ETF’s.

The great news about ETF’s is that you can thin slice and concentrate your portfolio to enable specific, concentrated bets that will make you more money. The bad news about ETF’s is that you can thin slice and concentrate your portfolio to enable specific, concentrated bets that will loose you a lot more money. Without conducting adequate research ahead of time, ETF’s can be a loaded gun. Make sure you don’t point it at yourself. That is where the Diary of a Mad Hedge Fund Trader comes in.

The bottom line here is that despite their many flaws and shortcomings, you can expect to find many more ETF’s in your investment future.

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