(By Ron) ETFs may not be the best thing since sliced bread, but they're still pretty darn handy. I'm not sure how we ever invested without them.
On the other hand, ETFs are not magic. They can't turn a bad idea into a money-maker, nor will they save you from costly mistakes. Like any tool, ETFs work best when they are used correctly.
ETFs almost always perform the way they should. They don't always perform the way you may expect. Today I will help you understand the difference.
Tracking an Index
The vast majority of ETFs are designed to follow an index. It can be a well-known benchmark like the S&P 500, or a little-known niche like Brazilian mid-cap stocks.
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Familiar or not, following an index is not rocket science. ETF sponsors know exactly which securities should be in the portfolio. They also know the amount allocated to each holding. So "tracking error" is usually minor.
|SPY goes right where it should.|
SPDR S&P 500 (SPY) is a good example. It's the oldest and largest U.S.-listed ETF. Look at any time period you want — you will find that SPY follows the S&P 500 with laser-like precision.
Extra-bullish investors who want to magnify their gains may buy ProShares UltraPro S&P 500 (UPRO). This ETF with built-in leverage is meant to provide 300 percent of the change in the S&P 500 index.
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This is where we start seeing problems. Look at the year ended 6/30/2012. During that twelve months, SPY's total return was 2.8 percent.
If SPY tracks the S&P 500, and UPRO tracks the S&P 500 times three, then you might believe UPRO should have gained 8.4 percent (2.8 x 3 = 8.4). It sounds simple.
In fact, it is not so simple at all. Instead of going up 8.4 percent, UPRO fell 9.5 percent. That's a difference of 17.9 percentage points. Whoa! What went wrong?
Actually, nothing went wrong. Investors just misunderstood how UPRO works …
Like most leveraged ETFs, UPRO resets its leverage factor daily. The triple-leverage part doesn't apply if you hold it longer. Over time, the variance can be huge.
This is why leveraged ETFs are useful only for short-term trading. They don't work if your horizon is longer than a few days. (See my Understanding Leveraged ETFs column for more explanation.) There is nothing nefarious about their long-term behavior. It can all be explained by rudimentary math.
Inverse ETFs Can Go Wrong, Too
A similar disconnect can happen with inverse ETFs. On the surface, these seem easy to understand. If the benchmark drops 10 percent, many believe an inverse ETF should go up 10 percent.
That's usually correct — on the first day you own the inverse ETF. The opposite is also true; your inverse ETF will decline in value if the underlying market rises on that first day.
However, as we saw in the UPRO example above, the inverse mechanism gets reset every day, causing long-term performance to be unpredictable. This is the case even for inverse ETFs that are not leveraged.
This variance can work either for you or against you. The point to remember is that these ETFs are unpredictable. Worse, they grow more unpredictable the longer you hold them.
Here's another example. SPDR Energy (XLE) is an unleveraged sector ETF, based on domestic large-cap oil and gas stocks. ProShares Short Oil & Gas (DDG) is an unleveraged inverse ETF representing the same segment.
As you probably know, energy stocks have had a rough time recently. An investor who bought XLE at the end of June 2011 had a 13.1 percent loss one year later.
What if this same investor had correctly forecasted the decline in energy stocks, and bought DDG? Would the loss instead be a 13.1 percent gain? No — DDG actually dropped 0.4 percent in this same year!
See how this works?
If you pick any given day and compare DDG performance with XLE on the same day, you will see a mirror image. But if you expand your view to a week … or a month … or a year … the results look more and more random. (See Three Often-Overlooked Risks of Inverse ETFs for more.)
What's the Bottom Line?
|Know what the tool is meant to do before using it.|
Am I saying to avoid leveraged and inverse ETFs? No, not at all. I should also point out that ProShares and other sponsors do all they can to help investors understand the full impact of daily resets.
Every tool has limitations. The fact that a hammer doesn't turn screws very well does not make it a bad hammer. It just means you need a different tool.
Leveraged ETFs and inverse ETFs with daily reset are great tools when you want to make a short-term bet. But if you stick around more than a few days, you may not get the results you expect.
In the end, you are the one who makes the call. Keep the right tools on your belt, and you will probably do just fine.
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