Do You Own the Worst Investment in the Stock Market?
An ETF is generally thought of as a basket of stocks designed to mimic the performance of an index or sector. They differ from a mutual fund in that they are not actively managed -- which lowers transaction costs -- and can be bought or sold as easily as a stock. SPY, QQQ and DIA are well-known examples of ETFs that track the S&P 500 (^GPSC), Nasdaq 100 (^IXIC) and Dow Jones 30 (^DJI) indexes.
The Future Can Be Very Risky
But not all ETF's are created equal. Some try to replicate the performance of commodities, like gold (GLD), silver (SLV), oil (USO), or natural gas (UNG), and that is where the trouble begins. Investors who use these ETFs think they are buying something with the risk profile of stocks -- but they are really buying the risk profile of futures.
It is not feasible for most ETFs to purchase the amount needed of the underlying commodity they are trying to track, so that leaves buying the equivalent amount in futures contracts.
Futures contracts by their nature are complex and -- more importantly -- are only good for a limited time. This means that old contracts are constantly being sold and newer ones are being bought, a process called rolling forward. The costs associated with this process -- mostly commissions -- eat into the value of the ETF over time, in essence making it a wasting asset -- and some would say a scam.
Lessons from the Bankruptcy of MF Global
James Koutoulas, who runs Chicago-based Typhon Capital Management, is no stranger to Wall Street scams. When MF Global, run by former Congressman and Goldman Sachs (GS) CEO Jon Corzine, filed for bankruptcy in late 2011 amid allegations of improper trading and misappropriation of funds, the firm froze all customer accounts, affecting about 50 of Koutoulas' clients.
Koutoulas immediately petitioned the courts to have his customers' funds transferred to new brokers, and when that failed, began a grassroots campaign to fight for his client's rights -- and the rights of all those affected by the MF Global fallout. This led him to form the Commodity Customer Coalition, which to date has managed to recover $6.7 billion in lost customer funds.
At a recent industry event, Koutoulas gave a detailed presentation on the pitfalls of certain ETFs. For example, between October of 2008 and June of 2010 the price of crude oil futures almost quadrupled, yet the ETF for oil, USO, stayed basically flat due to the cost of rolling the contracts.
And with VXX, an ETF that tracks the market Volatility Index, Koutoulas said it gets even worse. If you had invested $1,000 in the VXX when it was first listed in January of 2009, that investment would be worth less than $1 today, even though the VIX futures stayed in a relatively moderate range during that same time period. Once again, the underlying cost of rolling the contracts devalued the fund.
Time for Due Diligence
Not all commodity-based ETFs use futures. Some, like GLD, claim to physically hold enough gold to cover the value of their fund, though there is much debate in financial circles as to the validity of that claim and if it is even possible to do. But even some leverage stock ETFs like QLD use futures to enhance their performance as well.
The bottom line is that due to their structure, many ETFs are riskier than they seem and are not designed to be used as long-term investments. By investigating an ETFs prospectus first, investors can avoid those that will have a negative effect on their pocketbook over time.
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