Inner Beauty and ETFs

The ETF (exchange-traded fund) industry has exploded in the last 20 years. The very first ETF began trading in January of 1993, the S&P 500 Depository Receipt (SPY). Now there are well over 1,000 ETFs trading managing over $1 trillion dollars.

This is dwarfed by the $13T mutual fund industry but it's still very respectable, and growing.

ETFs have gone well past just 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 investments like 3-times the inverse movement of Japanese Government Bonds. I’m not kidding about the last ETF, its ticker is JGBD.

ETFs have gotten out of control and investors have gone right along with them. It's important now, more than ever, for investors to be extremely diligent when choosing which ETFs, if any, 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 a report I wrote titled “Build Your Wealth with Focus Markets.” Shoot me an email if you’d like a copy.

Luckily the due diligence process for ETFs is extremely easy to carry out as there are a number of online resources dedicated to evaluating these funds simply by searching for “exchange-traded funds.”

The focus of this week’s commentary is to try and impress upon you the importance of knowing the underlying holdings of your ETF or in the case of certain ETFs, how exactly they mirror the performance of particular markets like corn, cotton or our friend, the Japanese Government Bond.

Let’s start with the most basic 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 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 is an important distinction for emerging markets versus developed countries, there is another aspect of emerging markets that you need to 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.

The point of this commentary is not too quibble over the definition of an emerging market but rather the importance of not judging 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, its unlikely they could impact performance without movement from the Big 4.

We also now understand that the performance of EEM is closely tied to that of China and South Korea, who combined, represent over 30% of EEM. 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.

 

Leveraging A Point

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.

Simply put, 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 one of these ridiculous ETFs out 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 2 times leverage (IPLT) or German Bund Futures with 3 times leverage (BUNT), it’s not going to end well.

 

Back to Basics

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.

There are a number of ways that ETF mimic the various commodity markets. Some ETFs by 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. However, it’s important for you to be aware that there is a wide difference in the performance capabilities of the various ETFs that attempt to replicate the price movement of commodity markets.

I read an article 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 $577 (reverse split adjusted) on August 8, 2011 and has since declined 97%.

That’s a performance discrepancy of 26%. That’s kind of a lot.

Side note, TVIX is a 2-times 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 would be to focus more attention on his 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.

The 2-year rally that began when UNG bottomed on April 20, 2012, saw UNG gain 92% through the close on February 7, 2014, while Nat Gas futures contracts gained over 200%. That’s quite a difference in price movement. But not all is lost.

Some ETFs do a decent job of mirroring the price movement of their intended commodity market. From June 2012 through June 2014, the iPath S&P GSCI Crude OIL Total Return Index ETN (OIL) gained 36%, while Crude Oil futures contracts rallied 40% over that same timeframe. A price movement difference of about 4%.

Similarly with gold, State Street’s SPDR ETF (GLD) has declined 39% since peaking on September 9, 2011. Gold futures contracts have also declined 39% over that same time frame. The two instruments price movement has been identical over the last 3.5 years. So, while it is possible to use ETFs effectively to execute trades in commodity markets, it's extremely important that you dig a little deeper than simply the name on the ETF to truly understand what it is that you are investing in. When it comes to ETFs, beauty truly is on the inside.