Problems With Exchange Traded Funds

Exchange Traded Funds (ETFs)theory, Contango and Reverse Compounding.
First let's review the different types of ETF's and3.1 CONTANGO
what they give investors access to.To understand what Contango is you have to
1.0 ETF ESSENTIALSunderstand the difference between futures
ETF is short for Exchange Traded Fund and theymarket price and the commodities spot price. The
allow investors to buy a commodity, country'sdefinition of Contango is when the futures price
stock index, currency, or bonds. The use of ETFsof a commodity exceeds the spot price so if we
has exploded in recent years from 1 in 1993 tohad the spot price for oil is at $80.00 USD and
819 in 2009 (Source: ICI/SSgA) and givethe January futures are trading at $85.00 USD
investors access to:Contango exists. You may also hear the term
• 32 countries"Backwardation" which is just the opposite of
• 16 commoditiesContango.
• 14 currenciesMany new investors misunderstand the difference
• 30 different parts of the bond marketsbetween the futures price and the spot price and
Source: Matt Hougan, The largest ETFs withthink that commodity ETFs are solely a play on
respect to assets under management are:the spot price. They'll look at the difference in the
• SPDR S&P 500 (SPY) $85 Billionoil futures and the current spot price and come to
• SPDR Gold (GLD) $40 Billionthe conclusion that by investing in an oil bull ETF
• iShares MSCI-Emerging Mkts. $39 Billionlike USO, the ETF will go up in January where the
• iShares MSCI-EAFE $35 Billionfutures are trading at a $5 premium. They don't
• iShares S&P 500 $22 Billionrealize that the net effect on the ETF will be zero.
Source: National Stock Exchange 2.0 TYPES OFFor example say USO has $20,000,000 USD of
ETF 2.1March oil futures and has to sell all of them at
2.0 TYPES OF ETFs$40.00 USD/barrel (they can't take delivery as
2.1 BULL AND BEARthey have nowhere to store the oil) and then
A bull ETF will mimic the daily percentage changethey buy April futures at $50.00 USD/barrel. So
of whatever asset it represents. For example anUSO owned 500,000 barrels but once they
ETF that is based off of the price of oil willbought the April futures they'll only own 400,000
increase 2% when the price of oil goes up 2%. Ifbarrels. Now they have 25% less barrels but the
the price of oil falls then the ETF falls along with it.each barrel is worth 25% more than it was in
A bear ETF will move inversely to the dailyMarch so the net effect is zero. Also when they
percentage gain/loss of whatever assets itroll the futures forward to the next month they
represents. So an oil bear ETF will increase 2%have to pay a premium which will add to the
when the price of oil goes down 2%.funds cost.
2.2 LEVERAGE3.2 REVERSE COMPOUNDING
Many ETFs are leveraged so for a 2X ETF if theSince the goal of ETFs is to replicate the daily
underlying assets increase by 4% in a day thepercentage gain/loss of whatever asset the fund
ETF will increase by 8%. There are also 3X ETFsrepresents this will inherently lead to reverse
that will move 3 times the daily percentage gain/compounding over time. Here's a simple example,
loss however both of these ETFs are mainly usedif you have $100.00 lose 50% you will have to
for very short-term trades.make 100% on the remaining $50.00 just to get
3.0 PROBLEMS WITH ETFSback to $100.00. Obviously its very rare for ETFs
A lot of inexperienced investors figure that theyto move that much in a day but overtime with
can buy an oil ETF like HOU.TO or USO (which aresmall percentage moves the ETF will slowly start
bull ETFs) and when the price of oil increases into decay and this problem is exacerbated with
the coming years they'll make tons of money.leveraged ETFs.
Well there are two huge problems with this