With $30 Billion in Investment, Why ETFs are So Popular Among Investors?

Commodities are up. Oil and gold, silver and grains are vastly outperforming other investments. We noted elsewhere that ETFs and ETNs were a good way to take advantage of this uptrend if one wanted to get into this area. There are ETFs and ETNs that are leveraged. One can buy them and obtain one, two or three times the index’s gain or loss. The Financial Times (June 1; Steve Johnson) reported this just as we noted it. The ETFs have become very popular and have collected 30 billion US dollars in investments by the public. However, as noted before, there are dangers and risk here. Many people do not understand how they work.

Many advisors put their clients into these funds without fully understanding them. They have found that they are not providing the expected returns if held over a long period. They are made to buy and hold for a short time period. Johnson points out in his article that the leveraged equity ETFs are designed to be held for a day or so. They are held only during the compounding period; after that, they may lose money in a fast and spectacular manner. FAIR (Foundation for Advancement of Investor Rights) in Canada points out that investors lose money the longer one is in one of these leveraged funds whether you go long or short. As an example, their director pointed out a few examples. Gold rose 1 per cent over the first quarter of this year. In a double long leveraged fund, investors lost 46%of their value. In a two time inverse (shorting) fund, they lost almost 87%. FAIR cites another example of significant losses in a bear energy fund, even though energy prices dropped substantially as well.

There are some 94 such funds now in the US and they have grown rapidly. They are not popular in Europe. Volatility, if high, erodes the investor’s position in both long and short leveraged funds. One must be aware of the fund’s disclosure and understand the consequences. These ETFs are not as transparent as those that hold a simple basket of stocks. Pauline Skypala comments in the same issue cited above that the ETF resets its exposure daily to the index. If you are in and out in one day, you get the leverage you paid for. If you hold longer, the index is reset again and again each day. These ETFs use derivatives. They use a swap to eliminate tracking error. Derivatives introduce counterparty risk. Recall the investment banks recent encounter with counter party risk and what happened. These funds are essentially only a US phenomena.

They can return what they promise if you are aware of the consequences and exactly how they work: one day at a time.