More Is Not Always Better

The ETF (exchange-traded fund) industry has exploded since the very first one, the SPDR S&P 500 ETF Trust (SPY), began trading in January 1993.

The popularity of these vehicles has reached new heights recently because investors are fed up with the mediocre performance of active managers. In the last few years alone, investors have plowed almost $3T into passive funds while yanking over $1T from active ones.

Who can blame them?

Most active managers have failed to earn even decent returns in one of the longest bull markets we’ve ever experienced. Economically, this is one of the U.S.’s lengthiest non-recessionary stretches. If you can’t earn reasonable returns in this type of environment, why should investors continue to pay management fees year after year?

This insatiable appetite for passive investing has encouraged ETF creators to go 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 crude oil (OIL) to more esoteric strategies like three times the inverse movement of Japanese government bonds (JGBT).

Further evidence of the ETF industry going too far surfaced last week when the “ETF Industry Exposure & Financial Services ETF” (TETF) began trading. This ETF is composed of companies that are “driving and participating in the growth of the exchange traded funds industry.”

An ETF of ETFs?! Are you kidding me? What’s next, a Dennis Gartman ETF?

“The Dennis Gartman ETF is composed of securities guaranteed to lose value. This ETF will improve the tax efficiency of your portfolio by ensuring you have enough losses at the end of the year to offset the gains in your other investments.”

But seriously, ETFs have got out of control, and investors have followed 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.

 Inner Beauty Matters Most

It’s just like your mother told you about choosing a mate: the outside may attract you, but it’s what’s on the inside that matters most. This sage advice is especially true for ETFs.

Investors get so focused on the ETF wrapping that they forget these instruments are simply conduits to trade the underlying assets. Most people have no idea what’s inside their exchange-traded funds.

During the financial crisis, I had a healthy dose of iShares 20+ Year Treasury Bond ETF (TLT) in client accounts. One morning, TLT gapped down over 4% in premarket trading. I knew we were in the middle of some pretty heady stuff back then, but these were Treasuries! I called our trading desk and learned that a big chunk of the bonds being held in TLT had gone bid-less, meaning there was no market for them. Eventually buyers and sellers came back and the gap closed, but that was the longest five hours of my professional life.

I hope this anecdote highlights why it’s critical to know the inner beauty of any ETF before you invest even a dollar. That day, I could have traded in and out of TLT all session, but the lack of liquidity in the underlying bonds would have severely impacted the execution of those trades, and not in my favor.

But this isn’t a story about the financial crisis. It’s a story of underappreciated risk and the true nature of how ETFs operate. Last week, investors in the Direxion Daily Junior Gold Miners Index Bull 3X Shares (JNUG) came to appreciate this risk.

All That’s Gold Does Not Glitter

In the last year, assets in JNUG have exploded from $100MM to more than $1B. After the market closed last Thursday, this extreme demand forced Direxion to announce that "effective immediately, daily creation orders … are temporarily suspended until further notice." The reason for the suspension was “due to the limited availability of certain investments or financial instruments used to provide requisite exposure to the MVIS Global Junior Gold Miners Index.”

This suspension didn’t turn JNUG into Hotel California, but investors buying and selling shares on Friday couldn’t be guaranteed that the transaction price would accurately reflect the per share value of the underlying instruments.

Keep in mind that there was no exogenous shock or financial crisis that caused this disruption to JNUG’s order handling. It was just a run-of-the-mill trading day in late April.

This ETF is essentially crumbling beneath its own weight. JNUG gives investors leveraged access to a niche financial market that isn’t liquid enough to handle the billions of dollars flowing to it. Direxion can’t find enough places to stuff all the money that investors are throwing into JNUG.

This issue isn’t unique to junior gold mining stocks in Canada, and order handling issues like the one Direxion faced are only going to happen more frequently. Investors are jumping off the active management boat and stockpiling money in ETFs of all sorts. What happens when the same investors pushing all their chips to the middle of the ETF table decide to cash out?

Bottom Line

Keep this as your warning: sometime in the not-so-distant future there will be a market event that wipes out one of these ridiculous ETFs, destroying a lot of personal wealth and causing sweeping reforms across the entire ETF industry in the process.

Anytime there's an instrument that allows Joe Anybody with $100 and a smartphone app to trade the inverse of the base metal markets with two times leverage (BOM) or German Bund futures with three times leverage (BUNT), it’s not going to end well.

Don’t get me wrong — ETFs are an essential and highly effective tool for investors. But do yourself and your portfolio a favor by keeping it simple. The key to superior risk-adjusted returns is not loading your account with the most leveraged, esoteric ETF you can find. The key is to remain data dependent, process driven and risk conscious.

What’s in your ETF?