The Problem With Almost Every ETF Investment

by: Mark Anthony

I am telling you something every investor should know, but no one has told you! Even the most successful investors like Warren Buffett or Jim Rogers have failed to tell you this important investment rule that you are about to hear from me. I believe Jim Rogers does not intend to withhold his investment know-how from you, but he truly does NOT actually get it himself. It took me a while to get it as well.

When Jim Rogers pitched agriculture commodities and urged people to buy futures contracts of those commodities, he did NOT know what he was talking about! I hope that someone close to Mr. Jim Rogers can bring my words to him and explain why he was wrong. I have high respect for Mr. Jim Rogers and I hope he gets what I am about to say below. This is an investment mistake that 99% of all people make, including Jim Rogers himself.

If you believe something is bullish and you want to invest in it, then you must own it outright.

Allowing someone else to own your investments for you simply won't cut it. Owning something "indirectly", for example, by purchasing futures contracts, won't cut it either. If you don't hold something outright, physically, under your own control, then you really don't own it. If you don't own something outright, then all you have is merely a promise, written on a piece of paper. You are merely owning paper assets, not the physical assets. You should reject all assets that rely on a promise printed on a piece of paper. I will explain.

First, let me clarify that owning equities, i.e., owning shares of stocks of publicly traded companies, is NOT owning a paper asset. A company like the Stillwater Mining Company (SWC), whose stock I own, is a real physical business entity. If I push a computer button to buy shares of SWC through TD AmeriTrade, I do own a small piece of that company. My ownership is recognized as legitimate. If I have any doubt, I can request a physical stock certificate. If there is still any doubt regarding the ownership, then the stock should not be bought. So let's make it clear: Equities- as long as the ownership is not in question- are physical assets, not paper assets.

But all indirect ownership of physical assets, or ownership of derivatives of physical assets, are paper assets because they rely on a promise made by somebody, written on a piece of paper. Take for example the physical gold ETF, GLD, and physical silver ETF, SLV. Their respective investment prospectuses claim these funds are backed by physical gold and silver, and hence owning shares of these two ETFs are equivalent to owning actual physical precious metal.

Maybe these ETFs are really backed by physical metals, maybe not. We don't know. All I know is by owning shares of either GLD and SLV, you are NOT owning physical gold or silver. Not at all. You are owning something which is based on a mere promise, a promise that somehow, somewhere in a secret location in the world there are a pile of gold or silver bars and those bars really do belong to you, but you have no way of knowing and you have no access to it.

Make no mistake about it: You are owning a piece of promise, not a piece of metal, by owning GLD or SLV. It's up to you to decide how much you can trust that promise and how much you value it. But to me, I don't even trust my best friend to hold a few palladium coins for me, why should I trust some guys that I don't even know personally to hold my precious metal in a fund called GLD and SLV? In the past I scrutinized the metal bars list of SLV and raised plenty of red flags. I determined that regardless of whether those red flags have legitimate explanations, it is not worth risking my own investments to count on some Santa Claus to keep a good promise.

Other categories of ETF funds are even worse. The GLD and SLV funds at least claim to be backed up by physical assets. But there are ETF funds which are backed up by nothing but paper. Most notable are the USO fund for crude oil, and the UNG fund for natural gas. The USO fund does not own a single drop of oil and the UNG fund does not own a single cubic foot of natural gas. They own futures contracts, i.e. promises made by someone. Not physical commodities dug out of the ground. Why do people buy these two funds and then expect to make profits when prices of the underlining comodity goes up, if there is not an ounce of the actual stuff involved? They don't. I recognized that fundamental fact on Oct. 29, 2009. I advise you to read that article again. It was a very important lesson I learned.

Lucky for me, once I recognized why the investment based on paper will not work, I quickly unwound my entire investment in UNG, which was once the second largest position I held. I didn't suffer any loss and I never touched it again. In hindsight I have chills down my spine thinking what could have happened had I not realized in a timely manner what was wrong with UNG, and other similar paper-based ETF funds. Unluckily for many other investors though, they still buy such paper ETFs and think they are investing on the right thesis of bullish commodities, or a bearish U.S. dollar. These investors suffered great losses and will continue to suffer losses in the future, until they realize the problem with owning just paper. Or, at least until they lose all their money; whichever comes first.

Notice what the prices of crude oil and natural gas have been since the low of March 2009. And then note what the share prices of USO and UNG have been doing during the same period. Do I need to bring to your attention what FAZ and FAS have been doing over the long term? They are supposed to be a pair of opposite financial ETFs and they are supposed to run in the opposite directions. But over the long term, both run down. Same story with UUP and UDN, the dollar up and dollar down funds. In the short term they indeed run opposite to each other. But in the longer term, both run in the same direction: Downward. All those funds are paper instruments based on nothing but mere promises made by counter-parties. So why should anyone expect to make money out of these papers? Why do you think those counterparties are nice Santa Clauses ready to deliver profits to you happily? They aren't. These paper instruments are gambles, not investments.

There have been recent criticisms on UNG, on GLD and on SLV, and even on USO. I share some of the criticisms on these ETF funds. But no one on Seeking Alpha has really touched on the more basic reasons of why paper-based, or promise-based ETFs are fundamentally wrong as investment vehicles, regardless of the bullish fundamentals of the underlying commodities.

When it comes to investments, if you don't hold it, you don't own it. Please pause and think about it. Hopefully you will learn something. Hopefully, next time Mr. Jim Rogers tells you to buy agriculture commodity futures contracts, you can help me to explain to him why he was wrong: Why people should not buy this index or that index, or this or that ETF, or buy future contracts or other derivatives. Hoarding the physical stuff is the only correct way to invest in a commodity.

I still remember when I first pitched a physical tellurium investment. Many analysts, some well known, immediately asked me where they can buy tellurium futures contracts. I should have told them that I am quite happy to write up and sell them some tellurium futures contracts at good prices. But they are not going to make money out of me. If you want to make money from tellurium, you have to purchase and hoard physical tellurium, just like I did. It is true for all commodities. It is true for all investments. If you don't hold it, you don't own it.

Therefore I reject virtually all ETF investments as legitimate long term investment vehicles. If you want to invest in precious metals, you have to own the real metals, or own stocks of the related mining companies. I am happy to see that I am now vindicated. I will continue to do well in my insistence that palladium will be the best precious metal to invest in, and my focus on the only known primary palladium producers, SWC and North American Palladium (PAL). It was not a love affair. It was a firm conclusion based on my own objective investment analysis. I just wish that if investors are bullish on palladium, they should go out of their way and purchase any ounce of physical palladium they can find, instead of counting on buying palladium futures contracts.

Disclosure: The author owns SWC as the largest position on his investment portfolio, and is invested in physical palladium metal. The author does not have position in USO, UNG, GLD, SLV, FAS, FAZ, TBT, UUP, UDN, and does not intend to enter any position either. Although the author hoards physical tellurium and is skeptical of First Solar (NASDAQ:FSLR), he holds no position in FSLR.