Ray recently wrote about 10 tips on successful investing, and one of the things he mentioned was – Avoid “Exotic” investment opportunities. I think this makes sense because, a lot of times, exotic investments have nuances that impact their performance quite heavily, but are not clear or easy to understand.
Exotic
I looked at three exotic ETFs (ETFs= Exchange traded funds) or ETPs, and look at some such nuances.
1. Ultra Short ETFs: Short ETFs or Inverse ETFs are ETFs that gain in value, when the underlying index goes down. So, these are marketed as products that can help you hedge your investments. The really exotic ones in this category are the — Ultra Short ETFs.
Ultra Short ETFs are the ones that move double or triple their underlying index. So, if their underlying index falls by 5%, the fund itself will gain 10% or 15%. A lot of such funds give investors daily returns.
So, if the underlying index gains 3% today, your fund falls by 6%. The next day your fund will only have 94% of its value left with it, and even if the index were to fall and come back to its earlier level, you will be left with less than your full capital (because of the lower base).
This means that these funds don’t hedge very well over the longer term. If the markets are volatile, then such ETFs can lose a lot of money, even if the index itself doesn’t go anywhere in a period of say a month or two.
The ultra short ETFs, which give daily return, are only meant for investors who looking for short term instruments and are not really effective for long-term hedges.
2. 130 / 30 ETFs: Proshares recently launched its Proshares Credit Suisse 130 / 30 ETF, and it is the latest in the 130 / 30 Mutual Fund / ETN / ETF category.
A 130 /30 ETF can easily be categorized as an exotic product because it uses advanced strategies to try and attain alpha returns.
Here is how it works: there is a methodology, which is used to rank stocks from best to worst. After stocks are ranked; the fund goes ahead and buys the better ranked ones. At the same time, it shorts the lower ranked ones, and then with that money, it buys more of the better ranked stocks.
So, at any given time – the ETF is long 130% and short 30% (hence the name).
If the ETF has to generate alpha returns – it needs to pick the right stocks to go long and short on. If it doesn’t pick the right stocks, it will not generate alpha returns.
3. Hedge Fund ETFs: A few months ago, there was a lot of buzz surrounding the launch of hedge fund ETF — Index IQ (QAI). This was because this ETF seeks to generate hedge fund like returns.
When I first read about the fund, I thought it would invest in hedge funds directly because of the name and what it sought to do.
But I found out that the hedge fund ETF would invest in other ETFs and financial instruments, and has created an index that looks to replicate six strategies used by hedge funds. So, effectively this turned out to be a fund of funds.
As you can see, when it comes to exotic products, there is more than what meets the eye. Research and knowledge is needed to decide whether a particular fund is what you are looking for or not, and in case of exotic ETFs – this research is easily double or triple of what you would normally do.
This guest post was from Manshu from OneMint, a blog that focuses on personal finance, investing and economics. If you enjoyed his post today, please take a minute and subscribe to his feed
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Your article on this blog is fantastic.
Well done! I’m a big fan of your blog and be sure to keep up the great work.
I plan on returning and linking to your site.
Sincerely,
Alan H.
Be careful with leveraged ETFs. *Do not hold them long-term.* They are not meant to be held much longer than a month, and ideally, some analysts say they should be used for day trading or for trades under a week. This is because they rebalance so frequently (daily) and end up costing you quite a bit.
Thanks for the informative post. I’m curious about the leveraged ETFs. I understand about how they are rebalanced each day and how this can cause up and down movements to eat away at your profits (i.e. index: 100->110->100 causes the investment to go $100->$130->$91). Is this re-balancing entirely reflected in the price of the ETF? I notice that, for example, HXD has large changes between close price and open the next day, I assume due to the daily re-leveraging. So, if you purchase 100 shares, is your investment always 100 * daily price or are there splits/reverse-splits or other changes that you have to keep an eye on too? Regardless, I’m not foolish enough to invest in these since clearly I’m no expert (or a gambler).
The Re-balancing of leveraged ETFs can be a whole post, but the basics is that they try to keep the same securities:net asset ratio, so they buy when the index goes up (assets increases) and sell when index goes down (assets decrease).
your investment would be 100 * daily price, the stocks dnt split or reverse split on daily bases they just buy/sell the underlying security. But as you have noticed the moves can be fairly big and you can get hurt very bad if not careful.
It’s nice to play with these etfs with small amounts, but should not hold them any longer than couple of days.
Thanks for letting me guest post Ray.
@Ian: Rebalancing may not fully reflect the price of the ETF, because it is ultimately trading like a stock and price is determined by demand and supply on the market, at a particular time.
Watch out for deterioration of ETFs. Depending on what your interested in, commodity ETFs (HNU, HOU) contango effectnwill cause the value of your ETF to dimish significantly if your holding it for a period greater than 3-4 weeks. Triple leveraged financial ETFs (FAS, FAZ) can make you lose your shirt overnight. Ishares ETFs are more investor friendly, particularly for new investors. Mainly because their single leveraged. Also, XIU, XFN issue distributions, so that’s another positive.
Thanks for sharing such great post, it gives clear idea about investment, so it will help many people to understand.
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