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Overestimating Your Sophistication

Sometimes the simplest solution is the best.

Timothy Stauts, 08/31/2011

Mutual funds are still the primary investment vehicle used by retail investors, but exchange-traded funds have dramatically changed the landscape. Many investors have chosen some exotic ETFs because many noncore mutual funds have a number of restrictions that limit their availability to the average investor. For instance, some mutual funds impose investment minimums and have different share classes that charge varying fees based on how large your investment is. Moreover, the menu of available funds could vary depending on which brokerage an investor transacts through. Even higher hurdles exist with hedge funds and managed futures strategies, which are available only to accredited investors with a net worth greater than $1 million.

Many of those barriers no longer exist; ETFs have democratized investing by making several previously inaccessible asset classes available to the masses. One of the simple and best examples of this is gold. Through SPDR Gold Shares GLD, any investor can own shares in physical gold bars held in a bank vault in London, which rids investors of the inefficiencies and inconveniences associated with transporting and storing gold.

Of course, this enhanced flexibility comes with the downside of increased complexity. In some ETFs you'll find futures, forwards, swaps, foreign currency, and physical commodities. While most people understand how stocks and bonds fit into their portfolio, the implications of owning exotic derivatives are beyond the scope of most individual investors. And because there are no disclaimers that read, "You must be this tall to ride," it is critical that investors engage in sufficient self-assessment before venturing into products that may be beyond their comfort zone.

Today anyone with a brokerage account can invest in Russian rubles, South Korean small caps, cocoa, carbon credits, and short Latin American stocks with 300% leverage. While these funds might have their particular uses, they certainly do not belong in the average investor's portfolio. But because these funds are just as easy to purchase as your typical S&P 500 ETF, it can be tempting to add them. These sexier funds can be more interesting and fun to speculate on, but many investors get burned due to some dangerous misconceptions or a lack of complete understanding. Let's review some problematic situations.

Rolling Backwards
Thanks to market liquidity and the absence of carrying costs, using futures is, in many aspects, a better way to invest in commodities than owning them directly. However the strategy does have some major flaws. For example, if you have a bullish opinion on natural gas it is not practical to buy actual natural gas. Where would you store it and at what cost? Buying natural gas futures gives you exposure to price changes in natural gas but not direct exposure to the spot price. This is a key difference because the returns of a portfolio invested in futures contracts can deviate wildly from the returns of the spot price.

This is because futures contracts expire and need to be rolled to the next month. When the market is in contango, like it has been for the past few years, you lose money every month that the contract is rolled. A startling example of this is the returns for United States Natural Gas UNG. In 2009, the spot price of natural gas was up 3.37%, and the return of UNG was a negative 56.50%. At the end of 2009, UNG had $4.5 billion in assets, and I assume many of those investors thought they were getting the spot natural gas price and were sorely disappointed.

Compounding the Misery
Leveraged ETFs have received have received a great deal of press in the past few years--mostly for the disastrous effects they can have if held for an extended period. A majority of leveraged ETFs reset their leverage on a daily basis, which greatly increases volatility and produces substantial volatility drag on performance relative to the benchmark over time. For example, the financial sector represented by Financial Select Sector SPDR XLF is down 5.5% in the past year. If you decided to bet against financial stocks using the Direxion Daily Financial Bear 3x FAZ you might have expected to earn a return of more than 15% minus fees. Instead, because of the volatility drag created by the daily resetting of leverage, you would have actually lost 27.2%. This is one of the most painful investor experiences: correct thesis, wrong execution.

Jumping on the Bandwagon
ETF creators love to launch niche ETFs focusing on a popular trend. Alternative energy is one of those ideas; it's a concept that most people understand at a primitive level and want to succeed. It seems that if you could just invest now before it really takes off it would be a great long-term investment. Oh, if only investing were so simple.

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