3 Important Things to Know When Investing in ETFs

ETFs are cost effective, tax efficient, liquid and can be traded throughout the day (unlike mutual funds). Most investors are familiar with the appealing ETF basics, but here are a few tricks and traps the average Joe investor may not know.

ETFs (Exchange Traded Funds) have been called the best thing since sliced bread.

The ETF universe has ballooned to well over 1,300 ETFs, controlling nearly $2 trillion in assets. The $15 trillion mutual fund industry is less than thrilled about the splash ETFs made in their investment pool.

ETFs are popular for a reason, but this article addresses not only the ETF basics, it also reveals some tricks and traps the average investor may not be aware of.

ETF Basics

Know what’s under the hood: The initial success of broad market ETFs, like the SPDR S&P 500 ETF (NYSEArca: SPY), sparked much innovation and the need for additional ETF structures.

Today there are five different ETF structures, each with its own pros, cons, and tax treatment. In fact, in recognition of this diversity, what used to be called the ETF universe, has become the ETP (Exchange Traded Product) universe.

A detailed look at the different structures along with advantages and disadvantages is available here: Basic ETF Structures Explained

Diversification:  Most ETPs provide exposure to a basket of stocks or bonds. Most often that basket is linked to an index.

Some ETPs screen their holdings based on certain filters, are actively managed or designed to track the performance of commodities, currencies are other assets classes.

Cost & Tax Advantages: There are exceptions, as you would expect in any group numbering over 1,300, but ETPs in general are more cost and tax effective. The cheapest S&P 500 ETFs costs only 0.05% per year.

Liquidity: ETPs sell like stocks and can be instantly (assuming the market is open and you have a brokerage account) bought or sold with the click of a button. Mutual funds are redeemed (time delay is at least a few hours), often at a price that has yet to be determined.

ETF Tricks & Traps

Like every other investment, ETPs don’t come with a built in protection against moronic decisions.

The emergence of short, leveraged and leveraged short ETPs actually makes it easier for investors to lose (and make) money even faster. The epitome of a two-edged sword.

Due to the structure of short and leveraged ETPs, the odds of landing a profitable trade are not always 50/50.

Some leveraged (short) ETPs have a tendency to enhance returns in a down market, others in an up market. Sideways markets may deliver unpredictable returns, even returns unrelated to the underlying benchmark.

For example, the popular but notoriously declining iPath S&P 500 Short-term VIX ETN (NYSEArca: VXX) has been a trap for many investors.

The first chart below plots VXX against its benchmark, the VIX. I’ve inserted a 50-day SMA to show the basic trend. VXX has been down even though VIX has been trading predominantly sideways.

The second chart plots VelocityShares Daily Inverse VIX ETN (NYSEArca: XIV) against its benchmark, which is also the VIX.

You probably get the point. The choice of ETPs can influence the odds of winning beyond the normal odds dealt by the market.

More details about the subtle, but important idiosyncrasies of ETPs is available here: The Must Know Basics of Short & Leveraged ETFs

Know Thy ETF Universe

With over 1,300 ETPs comes the freedom of choice. The following criteria should be considered when on the prowl for the best ETP:

  • Cost
  • Trading volume
  • Performance track record
  • Structure and tax advantages/disadvantages
  • Tracking method (sampling or replication) and accuracy

ETPs also offer exposure to asset classes and currencies that, in the past, used to be off limits for the average investor. So take a stroll through the ETP universe. You may find asset class ‘galaxies’ that may harmonize with your portfolio on planet Earth.

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF to get actionable ETF trade ideas delivered for free.

Basic ETF (or ETP) Structures Explained

Much to the dismay of many mutual funds, ETFs have taken the financial world by storm. In recognition of the incredible variety available, ETFs are now considered Exchange Traded Products (ETP). Here’s a list of them along with advantages and disadvantages.

There are more than 1,300 ETFs with nearly $2 trillion in assets.

But not every ETF (Exchange Traded Fund) is created equal. In fact, the term Exchange Traded Products (ETPs) better describes what used to be called the ETF universe.

There are five different ETP structures. Although the difference in ETP structures may be subtle, they can affect overall returns, tax treatment and credit risk.

Here is a cheat sheet of the five ETP structures along with advantages and disadvantages:

Open-end funds

The vast majority of ETFs are structured as open-end funds, which is one of two types of ETF registered investment companies regulated under the 1940 Act. The open-end structure is generally used by ETFs whose primary objective is to provide exposure to stock and bond asset classes.

Dividends and interest received by an open-end ETF can be immediately reinvested, and derivatives, portfolio sampling, and securities lending can be utilized in the portfolio. Open-end ETFs that meet certain Internal Revenue Service standards are treated for tax purposes as pass-through entities (known as regulated investment companies), with income and capital gains distributed to shareholders and taxed at the shareholder level.

Advantages

  • Investors receive protections under the 1940 Act, as well as the 1933 and 1934 Acts.
  • Funds avoid cash drag through immediate reinvestment of dividends.
  • Funds can use derivatives, sample an index, and engage in securities lending.
  • Investors can access nearly any equity or fixed income sector or subsector.

Disadvantage

  • Funds have a limited ability to access alternative asset classes such as commodities or currencies.

Unit investment trusts (UITs)

A UIT is an investment company that holds a generally static investment portfolio and is used by a small number of ETFs that track broad asset classes. With no boards of directors or investment advisors managing the portfolio, UITs have less investment flexibility than open-end ETFs. For example, UITs do not reinvest dividends and instead hold them until they are paid to shareholders, usually quarterly. During rising markets, this can create a disadvantage known as cash drag.

In addition, UITs are not permitted to lend securities in the portfolios or use derivatives, and they must fully replicate the indexes they track. However, like an open-end fund, UITs are registered investment companies regulated under the 1940 Act and therefore offer the same level of investor protections as open-end funds. UIT ETFs that meet certain Internal Revenue Service standards are treated for tax purposes as pass-through entities (known as regulated investment companies), with income and capital gains distributed to shareholders and taxed at the shareholder level.

Advantages

  • Investors receive protections under the 1940 Act, as well as the 1933 and 1934 Acts.
  • A UIT is highly transparent because it fully replicates its underlying index.
  • A UIT has no investment manager to pay, which helps keep costs low.

Disadvantages

  • Since a UIT has no investment advisor, it is less flexible than open-end funds. (For example, it cannot use derivatives or lend securities.)
  • A UIT has a limited ability to access alternative asset classes such as commodities or currencies.
  • There is potential for higher tracking error due to cash drag.

Grantor Trusts

Grantor trusts are typically used by ETFs that invest solely in physical commodities or currencies. Grantor trusts are required to hold a fixed portfolio, as opposed to a variable one, making the structure ideally suited for physical commodities and currencies.

Because the nature of the underlying investments prevents grantor trusts from being classified as investment companies under the 1940 Act, grantor trust ETFs are regulated only by the 1933 and 1934 Acts. Therefore, while grantor trust ETFs must disclose regular financial information, they provide none of the additional investor protections laid out in the 1940 Act. Grantor trust ETFs also do not qualify for regulation by the Commodity Futures Trading Commission (CFTC), unlike partnership ETFs (described below).

ETFs that use the grantor trust structure consider investors direct shareholders in the underlying basket of investments. As such, investors are taxed as if they directly owned the underlying assets.

Advantages

  • Grantor trust ETFs are highly transparent because of the simple, fixed nature of the portfolio.
  • They have the ability to invest in alternative investments such as commodities and currencies.

Disadvantage

  • They are not regulated by the 1940 Act or the CFTC.

Exchange-traded notes (ETNs)

ETNs are issued as prepaid forward contracts that, like a bond, contractually promise to pay a specified sum—in this case, the return of a given index (minus the issuer’s expenses). ETNs are different from other ETF structures because they don’t hold any underlying assets. Instead, they represent a promise by the issuer (usually a bank) to pay a return. Investors in ETNs become unsecured creditors of the issuing bank and therefore need to take into account an additional risk—credit risk—when they are considering the purchase of an ETN.

ETNs have a preset maturity date, and they usually do not pay out an annual coupon or dividend. They are also frequently created for niche markets, sectors, or strategies, including commodities, currencies, and certain emerging markets. Since ETNs are simply a promise to pay a specified return, tracking error is eliminated once costs are taken into account.

ETNs are debt instruments, not investment companies. They are not regulated under the 1940 Act and lack many of the investor protections provided under that act’s framework.

Under current tax law, ETNs typically enjoy favorable tax treatment as prepaid forward contracts. Any accrued interest or dividends, and any appreciation in the value of the index, are generally rolled into the value of the ETN, so investors typically don’t incur taxes on them until the time of sale. However, it’s important to know your client’s tax bracket and investment time horizon, especially in light of some of the uncertainties surrounding the future taxation of ETNs.

Advantages

  • ETNs provide access to niche markets that could be difficult to track with a traditional 1940 Act ETF structure.
  • Tracking error is eliminated after factoring in costs. There is the potential for favorable tax treatment.

Disadvantages

  • There is the potential for significant credit risk.
  • There is the potential for concentration risk since ETNs tend to invest in very narrow market segments.
  • Investors in ETNs receive no protections under the 1940 Act.

Partnerships

Among the least common types of ETFs, partnership ETFs are unincorporated business entities—such as a statutory trusts or limited partnerships—that elect to be taxed as a partnership. Partnership ETFs are considered publicly traded partnerships because they trade on a stock exchange. They generally are treated as partnerships for tax purposes, which avoids double taxation at both the entity and the investor level. The income and realized gains and losses from a partnership ETF flow through directly to investors, who then pay taxes on their share. However, depending on what they invest in, partnership ETFs could be taxed as corporations.

Partnership ETFs can accommodate many different types of investments, including futures that provide exposure to certain types of commodities that are hard to store physically. For example, while grantor trust ETFs can be used to invest in gold or silver (commodities that don’t deteriorate over time and can be stored at relatively low cost), partnership ETFs generally track commodities such as natural gas and oil (which are difficult to store and lose their value over time). So instead of holding these items physically, partnership ETFs access these products through the futures market.

Partnership ETFs are usually regulated as commodity pools by the CFTC. While regulations by the CFTC include disclosure and reporting requirements, they are not as stringent as those required by the Securities and Exchange Commission under the 1940 Act.

Advantages

  • Partnership ETFs provide access to a broader range of investments beyond equities and fixed income.
  • Commodity-based futures ETFs are regulated by the CFTC and the National Futures Association and must comply with the Commodity Exchange Act.

Disadvantages

  • Investors in partnership ETFs must file a complicated Schedule K-1 tax form each year.
  • Investors in partnership ETFs receive no protections under the 1940 Act.

Information courtesy of the Vanguard Group.

Simon Maierhofer is the publisher of the Profit Radar ReportThe Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF to get actionable ETF trade ideas delivered for free.

Indicator Exposed: ‘Dr. Copper’ is More Quack Than Doctor

Myth or fact? Because of its use in many industry sectors, copper is a reliable indicator for the global economy and the stock market. The rationale makes sense, that’s why copper is said to have a Ph.D. in economics, but two charts oust copper as a quack.

Copper is said to be the only asset class to have a Ph.D. in economics because of its alleged ability to predict turning points in the global economy and stock market.

Here’s a quick sneak peek sound bite of what you’re about to read: If Dr. Copper was a surgeon; you wouldn’t want him to operate on you.
Dr. Copper Theory Explained
Copper is used in most economic sectors: Construction, power generation, power transmission, electronic products, industrial machinery, cars, etc.
The average car contains almost 1 mile or 75 pounds of copper. Additionally, copper is an excellent alloy and has become invaluable when combined with zinc to form brass and with tin to form bronze or nickel.
Copper is everywhere, that’s why demand for copper is often considered a leading economic indicator. The rationale makes sense, but is it true?
Copper – From Dr. to Quack
We will let the facts determine how reliable an indicator copper really is.
The charts below plot copper prices against the S&P 500 over the long-term and short-term.
The first chart goes back as far as 1959 and shows copper and the S&P 500 on a log scale. The dotted red lines mark copper highs, the dotted green lines copper lows. Shaded green bars highlight correct signals where falling copper prices predicted trouble for stocks.
It is somewhat difficult to correctly portray 54 years of stock market history on a few square inches, but it’s safe to say that copper, as an indicator, missed the mark more often than a Ph.D. should.
The second chart shows the correlation between copper and the S&P 500 from 2007 until now. The July 2008 copper high came too late to warn of the immediate post-2007 deterioration, but it was just in time to ring the alarm bells before the autumn 2008 meltdown.
The December 2008 copper low was a bit too early for the March 2009 stock market low, but correctly suggested higher prices until February 2011. Copper kept up a decent correlation until early 2012, but has been leading investors in the wrong direction ever since.
Copper’s Silver Lining
Remember that copper’s alleged predictive abilities can be seen as twofold:
1) As precursor for the stock market.
2) As precursor for the global economy.
By en large copper has failed as a leading stock market indicator (especially since 2012), but one can argue that the global economy has been deteriorating just as copper’s post 2011 decline suggested.
If it wasn’t for central banks’ coordinated inflation efforts, copper may have been right on both accounts.
Perhaps copper should be compared to ‘peers’ with an actual Ph.D. in economics – economists. Economists are generally bullish around major highs and bearish around major lows. Based on this benchmark, copper may well deserve its Ph.D.
What’s Next for Copper?
Right now copper is sandwiched between strong support around 3 and resistance at 3.2 – 3.3. Marginally higher prices seem likely. If resistance can be overcome copper may rally further. However, a drop below 3 should unleash much more selling pressure.
Copper ETFs
There are three copper exchange traded products (ETPs):
iPath DJ-UBS Copper ETN (NYSEArca: JJC)
United States Copper Index Fund (NYSEArca: CPER)
iPath Pure Beta Copper ETN (NYSEArca: CUPM)
All three copper ETPs are thinly traded, but JJC has thus far gained the most traction.

 

S&P 500 and Gold Sport Two Misleading Sentiment Anomalies

Groupthink tends to create losses for most and juicy gains for a select few. The S&P 500 and gold show some compelling sentiment extremes that could be misleading if viewed in isolation.

I love a good “reverse lemming” or contrarian trade. Investor sentiment is one of the best tools to spot a contrarian setup.

Even though the market has been stuck in a rut, there are a number of sentiment extremes. Many of those sentiment extremes however, parade some curious anomalies.

Love to Hate Gold

Last week Bloomberg reported that: “holdings in gold-backed exchange-traded products reached a record 2,629.3 metric tons yesterday,” an extreme sign of gold optimism.

More people than ever flock into ETFs like the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU). The fiscal cliff, QE3 and QE4 probably have something to do with that.

Gold futures traders on the other hand are quite bearish. Only 10% of futures traders are bullish about gold.

I have never seen such polar opposite sentiment for the same asset class.

Let’s Buy Stocks Before They Drop

Bank of America just reported that its private clients (retail investors) are selling stocks at the fastest pace in 19 months (see chart below). Such eagerness to sell tends to occur around bottoms not tops.

The behavior of option trades is the exact opposite of BofA retail investors. According to the ISE exchange, traders bought 208 calls for every 100 puts.

Such a rush into call options has pretty consistently led to lower prices in the past.

If you spend more time looking at other sentiment gauges, seasonality, technical patterns, cash flow, cycles of stocks vs. broad market indexes, and correlations between asset classes, you’ll find even more anomalies.

The thing is, anomalies – curious and unique as they might be – cause analysis paralysis, they don’t provide trade setups.

When in doubt, stay out or sign up for the Profit Radar Report to find low-risk trade setups. Low-risk setups provide sizeable profit potential in exchange for negligible risk, even in environments like this.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.