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Exchange-Traded Funds are arguably great tools for every day investors seeking to implement a variety of strategies in their portfolios. These funds allow investors to tap into strategies that were once reserved for professionals—like leverage and commodity investing—and they also permit so-called ‘lazy’ investors to build a portfolio cheaply and quickly, with minimal maintenance.

This has become even easier over the past few years as more and more funds have hit the market, bring the total number of ETFs well over the 1,000 mark and combined assets in the space over the key $1 trillion level. Yet, despite the proliferation of ETFs over the past few years, several misconceptions remain about the product type and how they not only work, but are designed to be used as well.

This is rather unfortunate as there is a great deal of education out there about the ETF market and how these new funds are built for investors. However, instead of learning more about the funds, many just blame the product, declaring these new funds somehow ‘flawed’, despite plenty of evidence to the contrary.

From what I have seen over the last few years, most ETF complaints and confusion center around a few key issues that are, time and time again, at the heart of investor misunderstandings in the exchange-traded fund market. Fortunately, all three of these ETF mistakes are easily explainable, and rectifiable, with just a few extra minutes of research and education (read ETFs vs. Mutual Funds).

 Below, we highlight three of the biggest mistakes investors make when investing with ETFs. Hopefully, this discussion will assist investors in better understanding how ETFs are designed to be used, and some of the main pitfalls that often slip investors up when they are looking at this relatively new product type:

1. Not knowing how Leveraged ETFs work

Despite many investors holding leverage ETFs over long time frames, most of these funds were designed to be held for a single day, and nothing more. That is because most of these products rebalance at the end of every session and are built to only give investors the corresponding amount of leverage over a single trading period.

The importance of this cannot be stressed enough, especially during oscillating markets with volatile funds. During this situation, an underlying index could move wildly, finish back at breakeven but the overall fund, thanks to leverage and rebalancing, could deviate significantly from this amount. Take for example this chart from Direxion:

As you can see, the index value is unchanged, but the cumulative fund return is negative, how can this be? Well, the daily rebalancing pretty much makes long term returns incomparable in the same way that a daily compounding bank account will not match one that never compounds; they are just two different ways of attacking the problem.

However, it should be noted that when markets are moving in a single direction—either up or down—the impact of compounding can actually work in your favor, leading to better-than-expected returns. Unfortunately, long-trending markets are relatively rare, especially when you are using 3x leverage in a fast moving sector.

Investors should also realize that most funds are structured like this, although not all are. There are a handful of monthly rebalancing ETFs that seek to only readjust once a month and thus can cut down on some of the issues that daily rebalancing funds face.

iPath has also recently debuted a series of non-rebalancing leveraged products, but these have their own problems as well. These ETNs do not stay at a stable leverage level, meaning that the rate of leverage is variable and can change from not only month to month but day to day as well. Thanks to this, the leverage can dip below or above what it was initially purchased at, meaning that investors may not always know—just by looking at the fund—what the true leverage rate is.

While this might be too technical for many, the moral of the story is; don’t use leverage products unless you understand them! The rebalancing can eat away at returns over long time periods so if you are dead-set on using these potent products, make sure to monitor them closely or only use them for short-time periods (for more on this subject read Understanding Leveraged ETFs).

2. Not understanding the futures curve’s impact on commodity products

The expansion of the ETF world into the commodity market has given investors a host of new ways to target natural resources. However, this has exposed new investors to a problem that they have never faced before; contango.

Contango is when the forward price of a futures contract is greater than the expected future spot price of a given commodity. As the contract date approaches, a commodity in contango will see its price fall in order to come closer to the spot price (Read Buy American with these Three Commodity ETFs).

Since many commodity ETFs use futures and cycle into the next contract month on a regular basis, they often face the worst of contango. In other words, many ETFs in the commodity world that use futures contracts ‘buy high and sell low’, a factor that often eats into long term returns in deeply contangoed markets.

A great example of this is in the VIX S&P 500 Volatility Index. While not a true ‘commodity’, this benchmark usually suffers from contango, and it has also had a terrible performance so far in 2012, losing about 36% YTD, at time of writing. Yet, the main ETN tracking the VIX, iPath’s (VXX - ETF report), has lost over 72% in comparison, as contango has ripped into any returns that VXX may have wished to accumulate in the time period.

However, it is worth pointing out that when a commodity is in the opposite environment, backwardation, investors can profit. In this situation, the ETF is constantly selling contracts close to the spot and buying ones further out on the curve for less.

In this type of situation it is relatively easy to make money, although most times commodities are not in this state. The entire problem can be avoided by looking at products that physically hold the commodity but these are relegated to the precious metal market, at least for now.

Another way to avoid the problem is to try and look for ‘contango fighting’ ETFs that seek to spread assets across the futures curve instead of continually buying the next month out. Products form Teucrium, United States Commodity Funds, and iPath’s Pure Beta series all do a solid job of this, although the problem of contango can never be completely eradicated (see Is USCI The Best Commodity ETF?).

3. Forgetting to delve into a fund’s holdings

ETFs are pretty transparent products, and are certainly more so than their mutual fund cousins. ETFs offer up daily disclosure requirements which are light years ahead of mutual funds which are only required to update investors once a quarter on holdings. Still, ETFs aren’t immune from stretching the boundaries a little when it comes to product names.

By this I mean ETFs can sometimes suggest one focus from their title but have a much different target when one looks at the underlying holdings. In other words, investors often assume that when a few ETFs have similar names they have pretty much identical holdings, this is usually not the case.

For example, the iShares Dow Jones US Home Construction ETF (ITB - ETF report) and the SPDR S&P Homebuilders ETF (XHB - ETF report) sound pretty similar, right? However, the products couldn’t be more different as ITB has roughly two-thirds of its portfolio in the home construction industry compared to just under 30% for XHB (read Top Zacks Ranked Construction ETF- ITB).

The trend is by no means limited to homebuilders, as the Gold Miners ETF (GDX - ETF report)  has, according to research from Global X for their Pure Gold Miners ETF (GGGG - ETF report), its fourth biggest holding in Silver Wheaton, and four companies in the top ten that derive less than two-thirds of their revenue from the yellow metal. Despite this, GDX is by far the most popular gold mining ETF on the market today, thoroughly crushing the competition.

One last example of this is in the case, although there are many others, is in the regional banking ETF (RKH - ETF report). Some of the ‘regional’ banks in the fund’s top five holdings include JP Morgan, Bank of America, and Citigroup. Unless regional means ‘the entire world’ this doesn’t really make much sense.

So ETF disclosures about positions are there for a reason, use them. While I wouldn’t say any of the fund companies highlighted above are lying or misleading about their holdings, many investors might not be getting what they are expecting if they just buy an ETF based on the fund name, making this easily one of the biggest mistakes that is made when investing with ETFs.

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