Exchange Traded Funds exploded onto the investment scene in 1993, and after less than two decades, the breath, depth and shear number of fund types, now at 1,000 and counting, continue to expand on exchanges in the United States today. An ETF represents a basket of stocks that attempts to mirror a specific index or sector in the market. They are a cleverly designed blend of stocks and mutual funds. The shares trade daily, just as with any other stock, but unlike mutual funds that trade once at end-of-day pricing. Their popularity stems from benefits related to their tax efficiency, cost structure, varied assortment, flexibility and built in diversification.
ETFs are also not restricted to just stocks. Commodities and currencies also have their own ETFs, as well as foreign indexes. You may want to refresh your knowledge of currencies with a forex trading guide since many of the foreign-based indexes will involve currency conversions in their valuations. Gold, oil and energy issues include many international companies in their portfolios for example.
At latest count, there appears to be at least eleven definable categories for this innovative investment vehicle. Number ten on the hit parade is an “inverse” ETF. An inverse exchange traded fund is assembled by combining various assets with derivatives and options to create profits when the underlying index declines in value. Basically, it’s an index ETF that gains value when the correlating index falls. It offers the possibility of being short in a sector of the market without the worry of a margin call. However, these funds have not been popular making liquidity a real concern.
Creativity from the investment community does not stop with inverse ETFs. The eleventh fund innovation is a “leveraged” ETF. Leveraged funds have been around since the early 1990s, but a leveraged ETF was not introduced until 2006. Leveraged ETFs are designed to include the securities in the underlying index, derivatives and debt in such a way that the return on the fund should be a multiple of the return on the index, typically targeted at “2x” or “3x” the return. These techniques have been used historically by Institutional Investors with great success.
Direxion is a company devoted to complementing core investment strategies of the sophisticated investor with tools that “may be used to hedge portfolio positions or seek profits from cyclical upward or downward market movements, all techniques which may add incremental risk-adjusted performance to your portfolio.” They offer a variety of leveraged ETFs. Two examples are the Direxion Daily Financial Bull 3X Shares ETF (NYSE:FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE:FAZ). Each attempts to target a 300% return on the Russell 1000 Financial Services Index. By providing both Bull and Bear versions of each of the indexes, Direxion gives investors the ability to seek competitive returns in rising and falling markets across a wide spectrum of diversified assets.
These funds and others like them are new and constantly evolving, but controversy surrounds their usage. First, there is a misconception that returns are on an annual basis, which is untrue. Funds are designed to provide multiple gains on a daily basis. This design can also produce negative multiple returns, a fact often overlooked when expectations are for profits. Lastly, the complexity of these funds and their management requirements cause tracking errors that are difficult to reconcile over a limited number of fund participants.
Leveraged ETFs are considered to be an advanced investment strategy. Although the usage of most ETFs is simple and straight forward, the leveraged variety involves a great deal more complexity requiring more due diligence before their use. They generally should be “tools” reserved for use by sophisticated investors, who can discern their subtle qualities and take advantage of the benefits they offer. However, investors of this type would most likely have the intellectual acumen to construct a leveraged portfolio on their own and to their own personal liking if the necessity arose.
Here are some more details on the Direxion Shares Daily Financial Bull 3X ETF (NYSE:FAS) and the Direxion Shares Daily Financial Bear 3x ETF (NYSE:FAZ) below. Be sure to visit our ETF categories for each ETF with more articles and insight on each fund.
The Financial Bull 3X Shares seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000® Financial Services Index (“Financial Index”). There is no guarantee the fund will meet its stated investment objective. The Russell 1000® Financial Services Index is a capitalization-weighted index of companies that provide financial services. As of April 30, 2008, the Index had 227 components, derived from the Russell 1000 Index with an average market capitalization of over $11 billion dollars and a median market capitalization of $4.4 billion dollars. One cannot directly invest in an Index.
The fund seeks daily investment results, before fees and expenses, of 300% of the inverse of price performance of the Russell 1000 Financial Services index. The fund normally creates short positions by investing at least 80% of net assets in financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. It is nondiversified.
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Disclosure: No Positions