Weapons of Wealth Destruction
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Some sophisticated ETFs look like interesting investing vehicles that make it possible to gain access to smart investment ideas. Under the surface, however, many of these instruments have some very material drawbacks that can be enormously detrimental for investors' returns. It is crucial to understand what's inside each ETF in order to avoid serious and destructive mistakes.
Climatic conditions over the last week have produced a huge rally in some agro commodity prices; due to the dry and hot weather corn is up a whopping 43% since June. But investors who bought Teucrium Corn Fund ETV (NYSEMKT: CORN), the exchange traded vehicle that's supposed to track corn prices, received a much lower 33% return in that period. It surely doesn't sound like a bad investment, but a 10% difference is worth noting. Even worse, the ETF is expected to do even worse in comparison to commodity prices over longer periods of time.
CORN does not invest in the physical commodity; it holds futures contracts with different maturity dates. This means that investors don't get exposure to spot corn prices, but to futures contracts that don't necessarily move in the same way as the spot. Besides, the instrument has added costs associated to rolling out the futures contracts as they approach expiration, and this puts the holder of the ETF at a stark disadvantage when returns are compared to those obtained by investing in the physical commodity.
In many futures markets, back month contracts are usually more expensive than front month contracts, a situation known as contango, which is quite habitual in natural gas futures, for example. For this reason, investors should not assume that United States Natural Gas Fund (NYSEMKT: UNG) is an efficient vehicle for tracking natural gas. Quite on the contrary. As the holding period of the ETF gets longer, its underperformance will probably get bigger as contango becomes a more important force in the return of the ETF.
Leveraged ETFs can be another source of trouble for long-term investors; these ETFs provide double or triple the daily returns of the indexes they are supposed to track, and daily is a key word here. Double or triple the daily return of an index doesn't mean double or triple that return over a month or a year. In fact, the higher the leverage level and the longer the holding period, the most likely it is that the leveraged ETF will become a losing proposition.
Let's suppose an investor buys a simple – unleveraged – ETF at $100 and returns over the next two days are 10% first and -9.1% later. The initial investment would grow to $110 in the first day and go back to $100 after the second day losses, so the investor would be right where he or she started at the end of the two-day period.
A triple leveraged ETF would gain 30% (10x3) in the first day and lose -27.3% (-9.1x3) on the second day. The ending value, however, would be much lower with a $95 price versus a $100 initial value. Please notice that this is due to the mathematics of leverage, and it has nothing to do with the ETF working badly.
Holding a leveraged ETF for the long term can be a very dangerous idea, and many investors have learned this lesson in the hard way. Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS), which is designed to provide the daily triple return of an index comprised of financial services stocks, used to be a popular bet in the aftermaths of the financial crisis by those willing to bet on a recovery via a diversified instrument. The instrument, unfortunately, has been a big deception for those who did not understand its functioning and true risks.
When the two negative factors, contango and leverage, are combined, the results can be disastrous. The VIX index is a measure of fear and volatility in the stock markets, so buying an instrument linked to the VIX when markets are optimistic and the VIX is low sounds like a smart idea for those looking to protect their gains in case things turn for the worse and volatility starts rising.
Unfortunately, the instruments used to track this index have some serious inconveniences. iPath S&P 500 VIX Short-Term Futures (NYSEMKT: VXX) suffers from a big contango effect. Even worse, VelocityShares Daily 2x VIX Short Term ETN (NYSEMKT: TVIX) ads leverage to contango. In the following chart we can see how both instruments have materially underperformed the index in the last three months, and the situation tends to get worse for longer time spans.
Some ETFs seem like attractive alternatives at first sight, but can be tremendously harmful when analyzed in detail. Investors need to understand what they are buying and how each instrument works in order to make the right choices for their portfolio.
acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.