What's in Your ETF?

The ETF (exchange-traded fund) industry has exploded in the last 20 years from the very first ETF that began trading in January of 1993, the S&P 500 Depository Receipt, SPY.

Now there are over 1,000 ETFs trading managing over $1 trillion dollars. This is dwarfed by the $13T mutual fund industry but still very respectable, and growing.

ETFs have gone far beyond simply allowing investors to mirror the returns of the S&P 500. ETFs allow investors to gain exposure to everything from commodities like natural gas (UNG) and oil (OIL) to extremely esoteric funds that seek to replicate 3x the inverse movement of Japanese Government Bonds.

I’m not exaggerating about the last ETF; its ticker is JGBD.

ETFs have gotten out of control and investors have gone right along with them. It's more important than ever for you to be extremely diligent when choosing which ETFs, to include in your portfolio.

I went through an extensive research process to choose the 8 ETFs that represent the Focus Markets.  I detail a fair amount of that process in my report “Build Your Wealth with Focus Markets.” Shoot me an email if you’d like a copy.

Know Your ETFs

Luckily the due diligence process for ETFs is extremely easy to carry out because there are a number of online resources dedicated to evaluating these funds. The primary information you must know is: the underlying holdings of your ETF or in the case of certain ETFs, how exactly do they mirror the performance of particular markets like corn, cotton or our friend, the Japanese Government Bond.

Let’s start with the most basis of ETFs, the iShares MSCI Emerging Markets ETF (EEM). Now, depending on your definition or understanding of what an emerging market is, you might assume that this ETF is a basket of countries like Columbia, Peru, Egypt, Turkey, etc. And in part, you would be right.

But a closer look at the constituent list and their weighting within EEM shows something else. The top 4 countries represented in EEM by weighting are: China (18%), South Korea(16%), Taiwan(12%) and Brazil(11%). These four countries represent close to 60% of EEM’s underlying holdings.

This means that as these four countries go, so goes the price of EEM. Not to mention that these countries don’t really represent what most investors think of when they think “emerging markets.”

Based on GDP, China is the world’s second largest country, South Korea is 12th, Brazil is 7th and Taiwan is 20th. Outside of Taiwan, this fund doesn't really seem to represent emerging markets the way most people define them.

Most people use some variation on the thought that emerging markets are countries whose economies are experiencing rapid growth and industrialization. And while I think that's an important distinction for emerging markets versus developed countries, there's another aspect of emerging markets that you must consider – emerging markets also can be characterized by countries that have capital markets that are progressing toward, but have not yet reached, the standards of developed nations.

By this definition, EEM is a solid representation of emerging markets. I'm not quibbling over the definition of an emerging market but rather the importance of not judging a book by its cover, or an ETF by its name.

Indonesia, Columbia, Egypt and Poland might show extraordinary growth but at a combined weighting of just over 10% of EEM, it's unlikely they could impact performance without movement from the Big 4. So by looking into the holding we have a better ideal that EEM is a good way to read China and developing Asia since China and South Korea represent over 30% of EEM.

INSERT CHART SHOWING EWY OVERLAY WITH EEM

Can you tell which line represents which ETF? Other than starting at different prices in January 2012, the price movement of all three is very similar and have a correlation range of 0.76-0.90, which represents an extremely strong positive relationship.

Don't Gator Wrestle With ETFs

Before I go on, let me say something about the general use of leverage in investing.

Leverage can be a great thing when it’s working in your favor and it can be potentially catastrophic when it goes against you.  Leverage is like gator wrestling -- better left to the professionals who can afford to gain the nickname Lefty as some kind of a badge of honor. 

More important, trading with leverage isn't necessary to earn superior returns consistently. There's no reason to ever trade a leveraged or inverse ETF and there is certainly no reason to EVER trade a leveraged-inverse ETF.

Keep this as your warning that some time in the not so distant future there will be a market event that wipes out one of these ridiculous ETFs and causes sweeping reforms across the entire ETF industry.

Anytime there is an instrument that allows Joe Anybody with $1,000 in an IRA account to trade the inverse of the platinum market with 2x leverage (IPLT) or German Bund Futures with 3x leverage (BUNT), it’s not going to end well.

OK, now that we’ve discussed why its important to dive deep on even a seemingly plain vanilla ETF and I’ve completed my public service announcement, let’s take a look at a couple of ETFs that give investors access to commodity markets.

And Now To Commodity ETFs

There are a number of ways that ETF mimic the commodity markets. Some ETFs use futures contracts and still others execute various derivatives strategies in an attempt to mirror the price movement of their chosen market.

There have been many articles written about these types ETFs over the years and some ETFs have developed a reputation for not being able to accurately reflect their intended market by a wide margin. A deep dive into how and why certain ETFs do a poor job of replicating performance is outside the scope of this commentary.

For this discussion, it’s important for you to be aware that there's a wide divergence in the performance capabilities of the various ETFs that attempt to replicate the price movement of commodity markets. I read an article earlier this week entitled, “The Perfect Trade for Increased Volatility: TVIX,” on TheStreet.com.

Frankly, I was drawn to the title because with a title like that, it’s bound to be anything but perfect. I’m going to resist the urge to strip Roberto Pedone, an independent trader from Delafield, Wisconsin of all of his dignity and I’m simply going to show you the performance of the actual Volatility index ($VIX) versus the ETF that attempts to mirror its performance (VXX).

The $VIX index hit a peak price of $48.00 on August 8, 2011. Since that time the $VIX has declined by 71%. The VXX ETF hit a high of $900 (reverse split adjusted) on August 8, 2011 and has since declined 95%. That’s a performance discrepancy of 24%. That’s kind of a lot.

Side note, TVIX is a 2x leveraged version of VXX, so use your imagination. If levered ETFs are a bad idea, I can assure you that nothing good will come from risking capital in an ETF that is levered to a derivative of the $VIX index.

My advice to Mr. Pedone: Focus more attention on international business studies at the Milwaukee School of Engineering.

The commodity ETF with the worst reputation for deviation from price performance is the US Natural Gas Fund, LP (UNG). This ETF has had more bad articles written about it than Miley Cyrus.

Since bottoming on April 20, 2012, UNG has climbed 75% compared to a 124% rally in Nat Gas futures contracts. That’s a difference in price movement of 49%. But not all is lost.

Some ETFS do a decent job of mirroring the price movement of their intended commodity market. The iPath S&P GSCI Crude OIL Total Return Index ETN (OIL) is up 15.6% since bottoming on June 29, 2012 and Crude Oil futures contracts are up 19% over that same timeframe. A price movement difference of about 3%.

Similarly with gold, State Street’s SPDR ETF (GLD) has declined 31.1% since peaking on September 9, 2011. Gold futures contracts have declined 30.6% over that same time frame. A price movement difference of 0.5%.

Bottom line: It's possible to use ETFs effectively to execute trades in commodity markets, but it's extremely important that you dig a little deeper than simply the name on the ETFs before buying them.