The Troubling Evolution of Exchange-Traded ‘Products’

by Kyle Woodley | June 7, 2012 9:30 am

It’s sad when such a sweet, simple concept can become so bastardized.

On January 29, 1993, State Street Global Advisors put forth a product that offered the diversity of a full portfolio, the agility of a stock and a cost that would make a mutual fund manager blush. That product? The Standard & Poor’s Depositary Receipts — known to you and I as the SPDR S&P 500 ETF (NYSE:SPY[1]), the first U.S. exchange-traded fund.

Twenty years later, we find ourselves in somewhat of a perception pickle. The SPY marked the beginning of the exchange-traded product industry — a market now with thousands of products and more than $1 trillion under management[2]. ETFs are a frightening and very real threat to mutual funds — according to the Investment Company Institute (via Bloomberg[3]), “U.S. investors added $4.82 to exchange-traded products last year for every $1 they deposited with mutual funds.”

But along with this breakneck growth has come deformity, exemplified by the industry’s very own name: “Exchange-traded product.” It’s a necessary term bred from the mutated evolution of exchange-traded funds into items like exchange-traded notes[4] — debt securities all gussied up like funds that track indices like funds do but aren’t really funds. Exchange-traded products have become trader playthings that tempt investors with offerings of double and triple “returns” or the ability to play “fear.”

The Reformed Broker[5]’s Josh Brown sums up this path to growth in ETPs in his usual insightful, punchy way[6]:

“Innovation is great, but we have to accept the fact that there will be failed and even dangerous innovations along the way. In my view, we are at the stage now where many dangerous notions are being productized — so it is up to the individual to not do stupid things with new vehicles they don’t truly understand.”

He couldn’t be more right. So, it’s up to individual investors (read: not day traders) to do two things:

  1. Arm yourself with knowledge.
  2. Don’t put your money where your brain isn’t.

While I can’t offer to stay your hand as you guide your mouse toward “buy,” I can at least help with the first task. Here’s a few “dangerous innovations” and other exchange-traded products you should approach with caution — or not even approach at all:

‘Double Dividend’ Funds

These products come first solely because they’re fresh on the mind. I recently discussed these funds[7] — the ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (NYSE:DVYL[8]) and ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (NYSE:SDYL[9]) — and their dangers, but the gist is this: These exchange-traded notes are just like any other ETNs in that their performance is tethered to an index, sure, but they’re debt securities to the core.

What does that mean? Well, it means products have the potential to perform in ways that have little to do with the index they track, like the VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX[10]) did in March. Issuer Credit Suisse (NYSE:CS[11]) basically stopped production of units in February, causing a bubble in demand, then said in March it would begin reissuing them again — causing the TVIX to tank[12] in the face of new supply, knocking 50% off the ETN’s price. That drop had nothing to do with the underlying index.

And thus, it means that you’re not necessarily getting double the returns from the equities that ETNs track, nor are you getting double the dividends they release — you’re getting the commensurate amount from UBS (NYSE:UBS[13]). So, just hope nothing happens to UBS.

The reason the ETRACS products get a special nod here is because of their moniker. Investors have been rushing into income stocks and funds in recent months, so needless to say, the attraction of a product that combines “2x” with “dividend” is a recipe for investor calamity. Yes, buyer beware, but we don’t live in a perfect world, and many people unfortunately invest in what they don’t know.

Now you know.

Other Reassuringly Named ETNs

Along with the “double dividend” funds, here are a few other ETNs that might accidentally give you the warm ‘n’ fuzzies:

And in cases like the emerging-market and bond ETNs, several legitimate ETF options are available.

Hedge Fund Alpha ETF

Of course, some exchange-traded products are less nefarious and moreso questionable concepts. The AlphaClone Alternative Alpha ETF (NYSE:ALFA[20]) is among those fitting in here.

ALFA basically tracks long positions[21] by (according to its proprietary methodology) the best-performing hedge fund managers. Which, in and of itself, isn’t a bad idea — as much as we like to crow about when the so-called “smart money” makes head-scratching moves[22], there’s usually a reason the “smart money” has a lot more money than you or I.

However, the problem is ALFA can only track these acquisitions once they’ve been disclosed, which usually doesn’t happen until months after a position has been initiated. By that point, these hedge fund managers easily could have liquidated their positions, taking profits in anticipation of a drop.

We complain if stock price updates aren’t real-time — so why would you invest with a potentially several-month tape delay?

Frontier Market ETFs

Again, totally legitimate, but again, probably should be avoided by the majority of long-term investors.

“Frontier markets” don’t have a locked definition, but they’re essentially considered to be much more exaggerated “emerging markets.” Because they’re lesser-developed markets, frontier markets have the potential for explosive growth. However, they also involve countries with looser corporate regulations and often extreme political volatility, and many of the companies release much less information than is available from more developed countries’ businesses.

Right now, the Guggenheim Frontier Markets ETF (NYSE:FRN[23]) is pretty much the only widespread game in town, though I wrote back in April that MSCI Inc. (NYSE:MSCI[24]) is creating a spin-off frontier markets index[25] in anticipation of a BlackRock (NYSE:BLK[26]) iShares ETF. Van Ecks also offers more targeted funds for Africa (NYSE:AFK[27]) and the Gulf States (NYSE:MES[28]).

No matter how you get your flavor, though, the sheer risk involved is more on par with gambling than investing. Even with the diversity offered by an ETF, the potential for companies to just implode, or get taken over by the government, etc., is enormous. But once upon a time, India and China were also “frontier markets,” so the allure at least makes sense. If you do decide to tangle with these, it should be with a small part of your investment money that you can afford to lose on a high-growth gamble.

Kyle Woodley[29] is the assistant editor of InvestorPlace.com[30]. As of this writing, he did not hold a position in any of the aforementioned securities. Follow him on Twitter at @KyleWoodley[31].

Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. more than $1 trillion under management: http://investorplace.com/2012/06/income-hunters-buoyed-etf-flows-in-may/
  3. Bloomberg: http://www.bloomberg.com/news/2012-05-31/hedge-fund-etf-weapons-turn-dangerous-for-solo-investors.html
  4. exchange-traded notes: http://investorplace.com/2011/03/etn-etf-exchange-traded-note-ipath-commodity/
  5. The Reformed Broker: http://www.thereformedbroker.com/2012/06/04/state-of-the-etp-business/
  6. insightful, punchy way: http://www.thereformedbroker.com/2012/06/04/state-of-the-etp-business/
  7. recently discussed these funds: http://investorplace.com/2012/05/double-dividend-funds-slow-down/
  8. DVYL: http://studio-5.financialcontent.com/investplace/quote?Symbol=DVYL
  9. SDYL: http://studio-5.financialcontent.com/investplace/quote?Symbol=SDYL
  10. TVIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=TVIX
  11. CS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CS
  12. causing the TVIX to tank: http://investorplace.com/2012/03/volatility-etn-tvix-rears-its-ugly-head/
  13. UBS: http://studio-5.financialcontent.com/investplace/quote?Symbol=UBS
  14. DJP: http://studio-5.financialcontent.com/investplace/quote?Symbol=DJP
  15. GRU: http://studio-5.financialcontent.com/investplace/quote?Symbol=GRU
  16. JJC: http://studio-5.financialcontent.com/investplace/quote?Symbol=JJC
  17. EMLB: http://studio-5.financialcontent.com/investplace/quote?Symbol=EMLB
  18. INP: http://studio-5.financialcontent.com/investplace/quote?Symbol=INP
  19. LBND: http://studio-5.financialcontent.com/investplace/quote?Symbol=LBND
  20. ALFA: http://studio-5.financialcontent.com/investplace/quote?Symbol=ALFA
  21. tracks long positions: http://investorplace.com/2012/06/new-bond-etf-has-you-covered-cobo/
  22. “smart money” makes head-scratching moves: http://investorplace.com/2012/05/5-head-scratching-q1-moves-by-big-time-money-managers/
  23. FRN: http://studio-5.financialcontent.com/investplace/quote?Symbol=FRN
  24. MSCI: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSCI
  25. creating a spin-off frontier markets index: http://investorplace.com/2012/04/msci-tries-to-make-frontier-markets-safer/
  26. BLK: http://studio-5.financialcontent.com/investplace/quote?Symbol=BLK
  27. AFK: http://studio-5.financialcontent.com/investplace/quote?Symbol=AFK
  28. MES: http://studio-5.financialcontent.com/investplace/quote?Symbol=MES
  29. Kyle Woodley: http://investorplace.com/author/kyle-woodley/
  30. InvestorPlace.com: http://investorplace.com/
  31. @KyleWoodley: https://twitter.com/#%21/kylewoodley

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