ETF Risk And Reward Tradeoffs Today - What Will They Be Tomorrow Or Next Month?

|
 |  Includes: GLD, IBB, UUP
by: Peter F. Way, CFA

Summary

Where to find ETF profit prospects?

How to measure ETF risks – not just uncertainty.

How can Industry ETFs be compared against Leveraged Market Index ETFs?

How can Commodity ETFs be compared against Healthcare Stock ETFs?

How do they all look now, compared to one another?

Let's answer the last question first

This picture pits the most actively-traded, widely-held ETFs against one another on the basis of the two investment dimensions that matter most, prospective reward, and the potential risk it may take to earn that reward.

Click to enlarge

(used with permission)

Across the horizontal (X-axis) scale, partly camouflaged by the green section of this map, are measures of what market-makers [MMs] are afraid of suffering as percent losses when they must go short in order to help big-money clients get their volume buy orders filled in each of these ETFs.

Those potential upside price moves have counterpart downside price concerns when the MMs need to help clients get out of ETFs, sometimes in a hurry, by being that part of the "other side of the trade" buyer that is not present at the time from Mr. Market.

So how is risk being measured here for individual investors?

MMs hedge their risk exposures in both directions every day as $ billions are traded to help adjust portfolio postures, worldwide. What the MMs will pay out of what could be trade spread profits, and the way the hedge deals are structured, tell just how far their price change fears extend - in both directions.

But the MMs risks are not the ETF investor's risks, being only short-term until the ETF position exposure can be unwound, and the hedge deal reversed. Still the MMs judgments involve longer concerns that the brevity of their initial direct involvement. The options and or futures contracts involved in the hedges carry legal obligations for at least one side of the subject that extend into the time period up to the contract's expiration date. That enters into the hedge cost at the outset and lingers through the contracts' lives. It helps to define the upside vs. downside proportions of the uncertainty present in each ETF's appraisal.

So we look to see what has happened to ETF prices following past times where the MM forecasts had proportions like they do now. Our interest is both in how credible the current upside forecast may be, and how real the downside price damage might be.

To make that as real as possible, for every day's forecast available in the past 5 years that had the up-to-down balance like today's, we look for the worst case of price drawdown in the 3 months following the forecast date, below the market quote at that date. Then we average all of those worst experiences.

That is the real risk exposure for the investor, needed to pit against the implied payoff promises. It is what is reflected on the left-hand vertical (Y-Axis) scale in the red area.

How to deal with the ETF subject and holdings differences?

Each of the numbered X-Y point squares in the map locate the gain-to-pain tradeoff for one or more of the ETFs identified in the blue-background field area.

What is being compared with both X and Y in each case is potential price change, which has been derived from the well-informed, highly-motivated, experienced judgments of a community of professionals operating in a competitive, cannibalistic environment. Further, those judgments have been credibility-tested against numerous actual prior experiences. The Xs and Ys have been made as common-denominator as may be possible.

So, like the spaghetti sauce, "it's in there", all the what-ifs and how-comes that may stem from differences that could arise from the subject matter. Whether an ETF has 5 holdings or 5,000, of big-caps or Greek stocks, physical gold or some leveraged investment strategy, it doesn't matter. X is X, and Y is Y. As an investor that's what we should be interested in.

Well then, what does this "map" tell us about where to go in the jungle?

Basically, good stuff is down and to the right, and worries are those things above the dotted diagonal. (unless you are looking for short vehicles, which is not our game.)

That makes [31] the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB), the logically most appealing tradeoff of the 78 subjects here, as far as wealth-building investors are concerned.

If instead, your desire is to get exciting thrills-and-spills entertainment without a care about capital damage, maybe a [36] leveraged short silver ETF play will do it for you.

Instead, the safest (and least-gain-promising) ETFs look to be ones holding gold like the SPDR Gold Trust ETF (NYSEARCA:GLD) and taking positions on the USD like the PowerShares DB USD Bull ETF (NYSEARCA:UUP) at [9].

Conclusion

Our point here is the one made some time ago that investors need to identify what it is that they want their investment portfolios to do for them, how assuredly, and how quickly, and then judge, on a common basis, the alternatives that are available. Risk and reward are the criteria that matter the most, and are present in every alternative.

Keep your investment life as simple as is possible by finding qualified, skilled appraisers of those dimensions, who regularly prove their abilities, and follow their guidance in whatever way is comfortable for you. But look fairly frequently, several times a year, because the Xs and Ys are in constant motion, and ETFs can move all over the map. Put your money where it can do the most for you, and don't be afraid to move it when other players in this serious game make it advantageous for you.

You snooze, you lose -- either capital or time. Both are serious losses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.