Exchange-traded funds (ETF’s) are one of the most popular publicly traded entities to date. Making up over 40% of the market’s volume, ETF’s have become an overnight phenomenon for the mainstream investor looking for instant diversification and a diverse range of specifications to help mold a portfolio more suitable to his taste. ETF’s have been highlighted as the cure-all for diversification, the greatest thing since sliced bread. Nevertheless, there should always be some precaution used when investing, even in something seen to be as safe as an ETF.
Even good things when used inappropriately can be harmful to the user. Investors in ETF’s ought to pay attention to the internal make-up of the fund prior to thinking they’re getting everything they think they are. One of the greatest misconceptions regarding such funds comes off the initial glance of the fund title. Fund names often describe the securities invested within the fund, but they can also be misleading to the person who leaves it at that and fails to take a closer look at the assets held within.
For instance, take a close look at the Claymore/Beacon Global Timber Index ETF (NYSE: CUT). While advertised as an index fund of timber securities, a supposed defensive safe-haven during recessionary times, the fund actually trades alongside consumer products unlike the lush forestlands one would immediately assume w/ the fund’s title. Naturally one would have to dive into a little more due diligence to realize that the fund’s holdings primarily consists of companies that do most of their business w/ wood and paper products rather than serving as pure plays in the forest holdings business.
Another prime example of misleading nomenclature might lie in the leveraged funds that are designed to boast double or even triple the direction of a given index. Using swaps and other derivatives to help boost the performance of the company through leveraged money, such funds often fail to live up to their performance design in reality. A quick look at the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and its counterpart the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ) will show a rather unsettling understanding of how leveraged funds tend to work in reality. As counterparts designed to operate in tangent with each other, an investor would be led to believe that they would balance each other out in a given bull or bear market. Yet when compared in real life, despite natural correlations to a given bull or bear market, both funds greatly disappoint with their shares down more than half of their initial valuations as of today.
In the end, it’s a good idea for any investor to remember that ETF’s are not the silver bullet to your portfolio woes. They are the sharp knives to your financial kitchen, a tool to help you in your designing of a risk management recipe. Nevertheless, they should always be wielded with caution, and properly researched rather than blindly taken on as a lazy man’s means of investing at large.
