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Exchange Traded Funds (ETFs) in Today’s World

In January 1993, a new investment vehicle was listed for trading.  It was SPY, or the SPDR S&P 500.  It had all the right attributes and appeared to be a very useful trading vehicle for individual investors.  It was the first in a long line of ETFs, exchange traded funds.

Investing in an ETF gave the investor:

  • Diversification
  • A passive investment because the goal is to mimic, not outperform, a specific index
  • The ability to buy or sell shares any time the markets are open
  • Very low management fees

To me, these represented the ideal replacement for mutual funds and gave shareholders the opportunity to own a diversified portfolio that included only the type of stocks the investor wanted to own (large caps, small caps, pharmaceutical stocks etc).

These investments were passively managed.  That means there were no high-salaried managers charging excessive fees for their services in attempting to beat the market averages.  Why not seek outperformance?  First it requires a research team and frequent trading.  Those are expensive.  Second, data shows that most professional money managers are unable to consistently beat their benchmark indexes.  Sure some managers did very well, but the difficulty is finding those mutual funds before they outperform, not after the fact.  By eliminating such managers, ETFs aim to earn 'average' returns.  This significantly reduces costs and the savings are passed along to the investor.

The managers use cash to buy a portfolio that comes very close to replicating the performance of the specific index being mimicked.  However, a bit of intelligence is required.  These managers do not buy every stock in large indexes because some are illiquid, and trying to buy or sell them can move the market.  Thus, IWM, which mimics the Russell 2000 index does not own all 2,000 stocks in the index. However, the correlation between IWM and the Russsell Index is near enough to 1.00 that it's not necessary to own each stock.

One other important advantage was that investors could buy or sell during the trading day.  Mutual funds allowed trades to occur only after the market closed for the day and the net asset value had been determined.  That's very inefficient for traders and investors.

In my opinion, ETFs were an excellent investment choice.  And to make them even better, all actively traded ETFs eventually had options listed for trading.  Traders could employ their favorite option strategies on a diversified portfolio – a less risky proposition than trading options on individual stocks.

 

Inverse ETFs

Next came bearish, or inverse ETFs.  Instead of selling an ETF short, an investor could purchase the bearish ETF to meet the same investment goals. This was a sound idea for an investment vehicle and made it easy for those investors who may prefer not to hold short positions.

 

Leveraged ETFs

Then came the leveraged ETFs which were supposed to perform as if they owned twice (or thrice) as many shares as the 'regular' ETF.  In other words, the investment objective for these ETFs was to move higher or lower by two or three times as much as their 'regular' unleveraged counterparts.  These instruments became very popular with the investing public. And that's the problem.

The leveraged ETFs are designed for day traders and very short-term swing traders.  They are not designed for buy and hold investors.  Despite the warnings, too many individuals bought these leveraged (both bullish and bearish) ETFs and suffered the consequences.  As has been described elsewhere, leveraged ETFs are designed so that's it's likely they will slowly lose value – and owning them as an investment is simply tossing cash into the trash.

Don't try to save on commissions in this scenario.  Instead of owning one 3X ETF, it's safer to own 3X as many shares of the original, unleveraged ETF.

 

Commodity ETFs

Most commentary regarding commodity ETFs is that they significantly underperform their underlying commodities. [Here is one example.]  Whether that's the fault of bad portfolio management or poor design of the investing algorithm, is unknown to me. Some professional traders consider commodity ETF managers to be patsies and claim it's easy to make good money by taking advantage of the ETFs monthly required trading (closing front-month positions to open next-month positions).

If owning an ETF does NOT simplify the investment process at a reduced cost and provide comparable (to owning the underlying asset) returns, then there is no reason to trade ETFs. 

 

Bottom Line

In today's world, there are a huge number of ETFs (~800) and collectively, investors have poured almost $800 billion into them.  Many ETFs continue serve a useful purpose, as described above.  However, in recent years ETFs have become complex, difficult to understand trading vehicles, and it seems to me, are designed for the sole purpose of earning profits for the ETF manager with little concern for their suitability for investors.

When choosing to trade ETFs please be certain that the specific ETF is designed to do as you anticpate.  No one likes to spend the time reading a prospectus, but please do not invest blindly. 

 

Another view: This from yesterday's Abnormal Returns (if you don't follow this blog, do so):

That is not to say there are not problems with the ETF industry.  As with all financial products the ETF industry seems to be living up to the old motto of MTV:  “Too much is never enough.”  We have written extensively** about the proclivity of the ETF industry to create me-too and poorly designed funds.  One could also argue that the rise of indexing has helped distort the pricing of individual securities.  There is little doubt that the rise of certain ETFs have changed the underlying dynamics of certain markets.  Further one cannot discount the possibility that additional market meltdowns could be exacerbated by ETFs.

All that being said, the rise of the ETF industry has been net-net a boon to investors.  The allocation of assets in ETFs reflect the collective decision of millions of professional and amateur investors alike.  If the underlying prices of those assets are ultimately proven incorrect, then those investors will pay the price.  In the meantime they provide many investors with the means to invest in a wide range of asset classes in a relatively cost efficient manner.  In that respect, the ETF experiment has to-date proven a success.


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Abandoning your favorite option strategy? Reconsider

An excellent post by Jared at Condor Options was also picked up by Abnormal Returns. [If you are not familiar with the work of Tadas at Abnormal Returns, it's worth the visit.  He finds the best blog posts, and it's more than I can find time to read.]


Jared suggests treating a strategy as you would a favorite stock: Buy on dips:

"If you’re trading a strategy with a long-term record of solid
performance… a great time to increase
your exposure to that strategy is after the strategy has suffered a
losing period.

In other words, given a strong and consistent strategy,
you should buy that strategy on the dips."

That is an interesting suggestion based on mean-reversion.

When investing, and more often when trading, we tend to buy on dips.  We remember price levels at which we had previous success when buying a certain stock. Technical analysts consider this practice to be 'buying at support.'  It makes sense.

However, I confess that I've never done that.  When a strategy is not working well, I tend to cut back, rather than expand position size. 

"A strategy that has performed well over the long run should never be
abandoned after a decline, unless there is overwhelming evidence that
something about markets or the strategy has changed so fundamentally
that the strategy will never work again."

When there is a solid, fundamental reason for abandoning a strategy, then do it.  But when the decision to change strategies is based on an expectation of further losses (with no solid basis for reaching that decision), that's an emotional decision.  Jared goes on to say:

"Based on my own experiences mentoring and educating option traders, I
think that the most important factor differentiating unsuccessful
novices from those who survive long enough to become experts isn’t that
the latter group knows more about the option Greeks, or is better able
to analyze implied volatility, or anything like that. The decisive
factor, as trite as it sounds, is that successful traders are willing to
base decisions on information rather than emotion
."

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Visit the new Options for Rookies Home Page, with links to new material, including my thoughts on an options education.

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Why are Investors Afraid to Trade Options?

It's Labor Day and the US markets are closed.  Enjoy the holiday.


In this blog post (Hat Tip: Abnormal Returns), Joshua reports about how the individual investor is discovering the forex markets.Trading volume is booming.

Joshua points out how and why this is bad for the future.  It's bad for the investors, it's bad for the professional trader, and ultimately, it will be bad for the industry.  However, the brokers who are steering their forex-ignorant customers into these dangerous markets, will make out well for now.  Until those customers lose their money and abandon trading.

I know that option trading can be used to gamble.  But that's not the fault of 'options.'  When the gamblers find any opportunity – be it real estate, mortgage-backed securities, commodities, or even options, then those gamblers are going to stay true to form.

When the inevitable happens, and the gamblers who buck the odds lose, often the blame is placed on the gambler's tool and not the gambler.

Options have an undeserved bad reputation in some places.  People who had a bad experience because of their ignorance when placing trades, people who bought far OTM options and anticipated miracles, people who ignored risk and just kept increasing the size of their trades in a desperate act to recover lost money – walked away from the options world, blaming everyone but themselves.

Using language that blamed their brokers, or the market makers, they tell others that options are something to avoid.

Blogs such as Options for Rookies, along with many others, try to spread options education.  I'm referring to blogs without the hype.  Those who promise 10% monthly returns are the problem that we professional option traders/writers face.  Lies, hype, expensive seminars and suckers taking the bait…  All of them contribute to the bad reputation for options.

All someone like me can do is try to tell the truth.  Options are a risk-reducing investment tool. Options can be used to increase the likelihood of earning money.  But this is not risk free.  It requires an education (that does not have to be costly), patience, practice and discipline.  It requires the ability to understand how to manage both money and risk.  Not everyone can do it.  That's the truth. Why isn't that publicized?

The connection to forex above?  A professional business writer and friend once carefully explained why she had so much hesitation in writing about options for her readers. 'First, do no harm' is her mantra.  And I agree with that.  Don't explain options so that they appear to be so attractive that people may rush out and do exactly the wrong thing.  That caution is understandable, and there is only so much information that can be written into a single newspaper column.

I accept the fact that saying nothing may be better than making the attempt to truly provide education.  However, that same friend recently wrote a positive story about forex trading.  Do no harm?  Forex trading is the biggest hustle out there.  Sure, superb traders may be able to grasp the intricacies or use technical analysis to make a living.  But the average investor who doesn't know the difference between the yen and the euro – how is that person supposed to get a handle on forex?  Almost impossible without a huge educational effort.  An effort that has not been made.  There is no attempt to educate.

The common hustle is to receive a cold call from a broker extolling the virtues of his system and why it's so profitable.  I always ask:  If it's so profitable, why are you making cold calls to earn a living?  That ends the conversation.

Seemingly responsible people seem to have no trouble with forex trading, but consider options trading to be risky.  The absurdity of that boggles my mind.  I find it very upsetting.

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I share some of my basic philosophy and thought on the markets in: Lessons of a Lifetime: My 33 Years as a Professional Options Trader.  Available as an e-book ($12) or Kindle version ($10).

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