Beware of Leveraged and Representative Exchange Traded Funds

With the evolution of the ETFs  market, they now covered numerous products and varieties. You are able to go long or short and you are able to take a leverage position of up to 3X. There is even a Bitcoin ETF in the making.

Most of the interesting ETFs are listed in the US markets whereby some are seriously just not suitable for the normal retail investors due to their structure.

The advantages of the ETFs have been widely preached with empirical studies showing most fund managers are not able to out-beat the market. So a passive approach with lower management fees and expense fees would be considered a more effective way of getting exposure to the markets. However, with the sales charges of most unit trust being cut to close to 0.5%-0.75% and if you chance upon a promotion, it could be even zero percent.

So this brings unit trust to be on a more level playing field. The spread of ETFs plus the brokerage commission could be equivalent to the 0.5%-0.75%. This brings it in line with the sales charge of unit trust. So the only thing that ETFs stand out will be the management fee which usually gives it an edge of around 0.5%-1% per annum.

However, some of us would not mind paying the extra in the quest to find the next Warren Buffet or Peter Lynch whom are able to give us market beating returns.

ETFs are mainly divided into replication and representative types. Replication types usually will buy the physical underlying to replicate the performance of the markets. On the other hand, Representative types are usually structured using derivatives products.

For those who are dealing with Representative ETFs and with added leverage feature, you have to be "Ready to Trade" rather than have a "Buy and Hold mentality". Most Representative ETFs make use of futures products to create a proxy for the underlying. Most futures exhibit Contango characteristics which means longer term futures contract are trading at a higher price than shorter term futures contracts which are usually traded as they are the most liquid.

So whenever the shorter term contracts expired, the ETFs managers would have to roll over to the next contract which they have to get at a higher price so it will lead to an erosion of the Net Asset Value since he can only buy fewer contracts. If you add leverage to the picture, it is definitely not an exciting proposition for buy and hold investors.

Citing an example, Ultra Short Vix ETF (UVXY) which has a leverage of 2X and was trading at around $11-$12 when Vix was near their range low of around 12 in Febuary 2013. Recently, VIX is back to around the 12 level and the same ETF is trading at around $3.5 (Not taking into consideration the 10 for 1 consolidation). Enough Said I Guess.

To conclude, for buy and hold investors, just stick to the normal replication ETFs with no leverage. For those into leverage and representative ETFs, do take it as a trading instrument which I personally will not hold for more than a month, unless it is moving in sync with your intended direction.

Lee