ETFs: Browse before you buy

An ETF, or Exchange-Traded Fund, is the fastest growing asset class in the investment environment. Although growing in popularity, investors should be wary of either the holding or strategy of certain ETFs.

An ETF trades on an exchange as a typical individual stock but is more like an investment fund that can hold practically anything. ETFs can vary widely from having an index focus such as the SPY, sector focus such as the technology XLK, bond focus such as the TLT, currency focus such as the FXE or commodity focus such as the copper JJC.

In addition, ETFs have been issued that are also “bear” focused so that the investor is short the investment holding, and finally, they can be 2x or even 3x leveraged plays of the investment holding. Finally, and most recently, “actively managed” ETFs have been approved and listed. That is, the portfolio manager actively trades the securities within the ETF based on the stated strategy.

One advantage for the retail investor has been the ability to package a well diversified portfolio without having to select individual securities. For example, some more astute investors can invest in an index ETF such as the SPY or DIA replacing the traditional index mutual fund and then purchase a very limited number of individual securities in order to overweight those securities in the index they are comfortable with and want to own.

A second advantage is that most, if not all, ETFs have options that all allow for effective risk management strategies. For example, an investor may be long the XLF (a well-known bank ETF) and after a significant run, can sell call options or purchase put options or both.

For institutional investors, the ability to overweight sectors vis-à-vis an index or benchmark or hedge a sector or portfolio as a whole are possible.

Let us focus on certain ETFs that are a little tricky and in which the investor must be careful to ensure that the investment underlying is the one they actually want to invest in. Specifically, these are ETFs in which a term structure for the asset exists. Most commonly, these are commodity, bond or volatility ETFs.

As an example, let us look at a commodity ETF that has a well traded futures term structure. This is natural gas and one of the most commonly traded ETFs is the UNG. UNG is an ETF sponsored by the United States Oil Fund LP.

Before we continue, one needs to understand the terms “contango” and “backwardation”. Contango refers to higher futures prices than the spot price (i.e. positive slope) and backwardation refers to lower futures prices than the spot price (i.e. negative slope).

UNG invests in the near month futures contract until it has two weeks to expire and then invests in the second contract.

At this point we have the question that needs to be asked – If I wanted to invest in natural gas shouldn’t the relationship be positive between the performance of natural gas and the ETF price?

Not exactly in this case and, the reasoning is rather evident. With two weeks to maturity, if the futures prices are in contango, the fund sells the near contract and buys the next maturity contract that is at a higher price. This is an obvious negative drag to performance. If the futures prices are in backwardation, the fund sells the near contract and buys the next maturity contract that is at a lower price. This is an obvious positive drag to performance.

If futures prices remain in contango for an extended period of time, the performance of the ETF can be quite different than that of natural gas itself, even if one expected the price of natural gas to rise.

As mentioned earlier, this issue is mostly present when the underlying investments are based on a term structure of futures prices. To alleviate this issue and to meet increasing investor demand for commodity based ETFs, certain sponsors are purchasing the actual physical commodity itself and storing it. This should allow for a purer play on the supply/demand price for the commodity.

VXX is an ETF whose performance is linked to the VIX CBOE volatility index. But once again, the prospectus indicates that the performance is linked to a rolling portfolio of one-month and two-month VIX futures contracts.

As with the UNG, the VXX performance relative to the VIX will lag with contango and will outperform with backwardation. Depending on the ETF, one must take the time to read the prospectus to ensure its understanding before the investment is made. As the saying goes…buyer beware.

Pascal Bancheri, CFA, is the president and principal of Sigma Management Advisors Inc.