ETFs and ETNs - Opportunity or Danger?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 31, 2011

IN THIS ISSUE:

1. Exchange-Traded Notes (ETNs)

2. The Downside of ETFs and ETNs

3. Know Thy ETF

4. How I Recommend You Invest in ETFs and ETNs

5. Metropolitan’s ETF Methodology

6. Metropolitan’s Performance

Introduction

As I noted last week, I am going to be vacationing in Italy just ahead to celebrate my 25^th wedding anniversary with my wife, Debi. We are actually leaving today as this E-Letter is to be distributed, so I have been burning more than a little midnight oil preparing this week’s issue as well as preparing for our trip.

This week, I want to revisit “Exchange-Traded Funds,” or ETFs as they are known in the industry, which have become quite the rage in recent years. I have written about ETFs before back in April of 2006, so I’m not going to spend any time discussing the basics. If you’d like to refresh your knowledge of ETFs, just click on the above link to review my previous article.

The ETF world has not been sitting idle since I wrote my last article, with literally hundreds of additional offerings now available. In addition, a new type of exchange-traded security, the Exchange-Traded Note (ETN) has now burst upon the scene. The explosion of ETF offerings and development of ETNs have some “experts” sounding alarms regarding their proliferation. We’ll talk about some of those warnings in this issue.

There’s little doubt that ETFs and ETNs are today’s “sexy” investment and many investors want to jump on the bandwagon. However, there are landmines that you need to be aware of along the way. That’s why I’m also going to introduce you to Metropolitan Capital Strategies, an Investment Advisor with a professionally managed ETF portfolio that merits your consideration.

Through April, Metropolitan’s flagship Tactical Growth Strategy has posted an impressive annualized return of over 11% since its inception, while holding drawdowns to only -6.25%. Of course, past performance can’t predict future results.

Impressive as these numbers are, the most unique aspect of Metropolitan’s ETF-based strategy is that it doesn’t issue a buy signal unless their proprietary formulas indicate a 90% confidence level of double-digit profits over the next market cycle. If the model is less than 90% confident of gains, the strategies remain on the sidelines, usually in a Fidelity brokerage cash account.

ETNs – The Newest Kid on the Block

To recap where I left off in 2006, ETFs can be defined as a low-cost index fund traded on the exchange like a stock. Unlike most mutual fund shares, ETFs can be bought and sold throughout the day just like a stock or bond. In most cases, ETFs are designed to mimic the performance of a specific stock or bond index, and the list of indexes available through ETFs has increased exponentially in recent years.

Back in 2006, another form of exchange-traded security was developed known as the Exchange-Traded Note (ETN). Today, many people use the term ETF to describe both Exchange-Traded Funds and Exchange-Traded Notes. There are even blog posts from investors claiming that they bought an ETN when they thought they were buying an ETF. Since ETNs and ETFs both trade on the stock exchange, some consider them to be equals, but the reality is that the two are significantly different.

For one thing, ETNs are a more recent development, with the first of its kind being issued in 2006. As a result, they were not discussed in my April 2006 E-Letter about ETFs. Another major difference between ETFs and ETNs is their makeup. Except for leveraged and “short” funds, ETFs are usually comprised of the individual securities that make up the index it is intended to mimic. In fact, you can actually take distribution of the underlying holdings when you redeem an ETF under certain circumstances.

ETNs, on the other hand, are a different breed in that they represent unsecured, unsubordinated debt of the issuing firm. Instead of paying a set rate of interest, ETNs are designed to pay a return equal to the performance of an underlying asset or index. As debt instruments, each ETN has a maturity date and is backed by the strength of the issuing company, usually a large investment bank.

That’s right, unlike an ETF, the ETN does not own any of the securities making up the index or commodity it is tracking. It’s simply a debt instrument, with a promise to pay a return based on the performance of an underlying index, nothing more. So, your ETN could take a hit if the credit rating of the issuer is downgraded even though the index or asset the ETN is tracking is increasing in value. This is what happened to investors holding Lehman Brothers ETNs.

ETNs have gained popularity lately because they offer access to classes of investments not previously serviced by ETFs. For example, ETNs have been developed to track the prices of various commodities. ETNs have also been developed to take advantage of restricted foreign stock exchanges as well as complicated strategies not easily adapted to ETFs.

Compared to ETFs, ETNs have both advantages and disadvantages. One disadvantage is liquidity. Yes, ETNs are traded daily on an exchange, but the true value comes from holding the ETN to maturity. Prices prior to maturity can fluctuate significantly and are not always in line with the current price of the index or asset being tracked.

On the plus side, ETNs tend to be more tax efficient than ETFs or index mutual funds. In my April 2006 E-Letter, I noted that one of the problems with ETFs is that they sometimes stray from the performance of the index they are intended to track. ETNs generally do not experience significant tracking errors per se IF held to maturity, since their value is based on the price of the index or commodity at that time. Prior to maturity, however, ETN values can vary.

Just as with any investment, ETFs and ETNs are not suitable for every investor. However, this hasn’t kept them from becoming the darling of the investment industry. Unfortunately, many investors pile into ETFs and ETNs without fully researching the downside of these investments, resulting in some very disappointing performance.

The Downside of ETFs and ETNs

Since my original article about ETFs back in April of 2006, there have been some major issues that have faced ETFs and ETNs. While both have become even more popular with investors, and the number and types of indexes tracked continues to increase, it has not been without some bumps along the way.

The ETF market still contends with some of the disadvantages I mentioned in my 2006 issue such as the failure to track the underlying index and low trading volume leading to wide bid/ask price spreads. As more and more ETFs and ETNs are developed that track lesser known indexes, these situations will no-doubt continue to be a factor in the future.

We have also had a couple of little-known terms gain importance as they relate to ETF and ETN performance. The first is “contango,” which used to be limited to commodity futures accounts. While I don’t have room in this E-Letter to fully discuss the concept of contango, let it suffice to say that it relates to price variations encountered when rolling futures contracts forward. The opposite of contango is known as “backwardation.”

Without getting into too much detail, the bottom line is that both contango and backwardation can affect the value of the futures that make up the fund or even the index being duplicated. As a result, both ETFs and ETNs are vulnerable to price swings that are unrelated to the actual price of the commodity being tracked.

Another term we have come to know recently is “flash crash,” derived from the sudden violent market drop and reversal that occurred on May 6, 2010. The jury is still out as to whether ETFs and ETNs helped to cause the flash crash, but we do know that they were disproportionately affected.

As a result of the flash crash, some firms have established circuit breakers to stop ETF trading in abnormal markets. Plus, ETFs have the right to reject redemptions, which can be activated to prevent a run on an ETF. This underscores the importance of doing your homework before making any ETF or ETN investment.

Know Thy ETF

Other problems experienced by ETF and ETN investors come from not researching and knowing how the security is supposed to work. Good examples of this are ETFs that promise a “2X” or even “3X” leveraged exposure to an underlying index. These securities are risky on the surface since 200% or 300% of a market move can be very exciting, but devastating if you’re on the wrong side of the market.

However, since these leveraged funds tend to be at the top (or bottom) of the performance charts, and investors tend to buy the latest “hot number,” many took on more risk than they actually intended to. That’s because some of the leveraged ETFs were designed to provide only a daily leveraged exposure to its underlying index. If held for longer periods of time, the return could erode significantly and result in a loss even though the underlying index was going up.

This situation, again, is very complicated to discuss and is beyond the scope of this short article, but it is generally related to volatility over the holding period. If the holding period is a single day, then you’ll get close to the leveraged return you expect if the market goes your way. Any longer and you’re taking your chances. Thus, these funds are suitable for frequent trading strategies, but may not be the best choice for a buy-and-hold portfolio.

Another reason to make sure you know your ETF or ETN well is the effect of trading volume, which I briefly mentioned earlier. It may be great to have exposure to a little-known index, but it might not do you any good if you have problems liquidating your position when you want to get out.

The same goes for bid and ask spreads on the funds and notes, which are not always easily identified when doing a trade. ETFs and ETNs with low trading volume will be more likely to have larger bid-ask spreads, which can greatly reduce the amount of gain or increase the amount of loss you might realize from your investment.

How I Recommend You Invest in ETFs and ETNs

I think we can all agree that there are a lot of advantages to investing in ETFs and ETNs, including lower expenses and more flexible trading opportunities. However, as I have highlighted above, this flexibility does not come without risk. It is imperative that you do your homework before investing in any ETF or ETN to know what you’re getting into.

Another alternative is to allow a trained professional to do the research for you and manage your ETF portfolio. We have found such an Advisor in Metropolitan Capital Strategies (MCS) of Manassas, Virginia. Sharon Snow, David Schombert and their staff have developed an ETF trading system that not only selects the asset class with the highest probability for gain, but also does the required research into the ETF contracts it uses to access these markets.

Metropolitan’s primary approach to managing money is based on two key concepts. First is the knowledge that market performance is seldom in a straight line. In any uptrend or downtrend, there are opportunities for outsized gains along the way. Of course, these opportunities don’t always materialize for domestic stocks, so MCS has expanded its horizons to include virtually any market or asset class covered by an acceptable ETF, including foreign and domestic stocks and bonds, commodities, currencies, real estate and so on. They can cover virtually all the bases.

The second key concept is risk management in order to preserve capital. One way MCS seeks to manage risks is requiring their proprietary model to reach a 90% confidence level that a trade will be successful before entering the market. While the goal is to identify market trends that last anywhere from seven weeks to four months, MCS will exit the market anytime its confidence level goes below 90%, such as they did in late April of this year. At those times, MCS remains on the sidelines in the lowest-risk asset class, usually cash.

Metropolitan’s Methodology

The MCS strategy is a balance of discretionary insight from fundamental analysis coupled with the mechanical discipline of technical analysis. As the primary portfolio manager, David Schombert has developed a proprietary process called Flexible Asset Class Trading, or FACT for short. FACT incorporates six technical, 26 fundamental and 25 economic factors into a trading model that helps David determine the market’s direction and which asset classes have the greatest potential for gain.

One of the most important facets of Metropolitan’s strategy, however, is the fact that there is a measure of manager discretion involved in investment decisions. I believe that a properly diversified portfolio should have both mechanical and discretionary strategies. That’s because 100% mechanical trading models have the advantage of not having to deal with investor emotions, but they also can’t read the newspaper to anticipate what we have now come to know as “black swan” events.

MCS incorporates both technical and discretionary analysis to provide a check on emotional trading while maintaining the ability to identify periods of time when global events are in the driver’s seat in regard to market’s movement.

Discretion in Action: A very good example of manager discretion was evident earlier this year when MCS reached a 90% confidence level but the issue of the Japanese nuclear power plant meltdown was still up in the air. David delayed entering the market until mid-March due to the possible market ramifications of a meltdown in Japan, where a mechanical system might have gone full steam ahead.

Because of the nature of the MCS strategy, typical historical gains have been in steps, reflecting an outsized gain followed by a period of time in cash. The performance graph below is indicative of a tactical asset management style that moves in and out of the market based on perceived opportunities.

Since MCS tends to trade infrequently, accounts spend an average of 50% of the time in cash at Fidelity. For taxable (non-IRA) investors, MCS offers an options overlay in their Tactical Growth Strategy that will actively trade covered and uncovered put and call options within tightly controlled risk parameters. Accordingly, the minimum investment for the Tactical Growth Strategy is $250,000.

Since options trading is not available to IRA and other qualified accounts, MCS also offers a Tactical Moderate Strategy which is managed exactly like the Tactical Growth, except no options are traded. Tactical Moderate is available to both taxable and tax-qualified accounts at a minimum investment of $100,000.

MCS Performance

Whether you are in the bull market camp or running with the bears, the MCS Tactical programs should be attractive to you. That’s because MCS is firmly committed to preserving capital, but they also seek double-digit returns when market conditions are right. While past performance can’t guarantee future results, I think it’s very impressive that the six times MCS has entered the market since the inception of these programs, all have produced gains.

Below, I have highlighted the performance of the MCS Tactical Growth Strategy for your review. Detailed performance information for the Tactical Moderate Strategy may be found at the following website link:

Tactical Moderate Strategy Advisor Profile

As you review the performance information below, you will note that MCS did not participate in the market rally that followed the March 2009 low in the stock market. David explains that the FACT system never reached a 90% confidence level even though the market was screaming higher. Looking back, however, this was a reasonable stance. I’m sure you will recall that as the market rallied in 2009, there was still a great deal of uncertainty in the market caused by massive government intervention in the financial markets. Plus, many analysts were calling for a correction, though it never materialized.

One of the most important performance statistics in the above presentation relates to the worst losing streak, or drawdown, of the Tactical Growth Strategy. While posting an annualized gain of over 11% since its inception, the worst drawdown has been only -6.2%. This is an impressive statistic, especially for those who want an exposure to ETFs but are also concerned about capital preservation.

The Tactical Growth and Tactical Moderate Strategies are offered on the Fidelity Institutional platform where MCS has access to hundreds of ETFs. Each investor opens a brokerage account at Fidelity and grants MCS the authority to trade the account. Note that MCS cannot withdraw assets from the account except for periodic management fees.

Conclusions

As the proliferation of ETFs and ETNs continues, we will no-doubt see increasingly flexible, yet complex offerings in the marketplace. We are also likely to see more and more obscure asset classes represented by ETFs and ETNs, though access doesn’t necessarily mean that the fund will perform as expected or have sufficient volume for effective trading.

Some alarmists claim that the way some ETFs and ETNs are structured and traded could lead to another financial Armageddon similar to the credit crash, but I don’t buy that. Since the credit crisis, there has been no shortage of so-called “experts” trying to identify the next catastrophe, so far without success. What I do believe is that individual investors can encounter their own individual financial Armageddon if they invest in the wrong fund without doing their homework.

That’s why I think Metropolitan’s Tactical Growth and Tactical Moderate Strategies are tailor-made for investors who want exposure to ETFs, but would like someone else to do the research and selection. No one knows what’s going to happen in the markets after the end of QE2, but it’s hard to go wrong with a strategy that has to be 90% confident of a meaningful gain before jumping into the market. Whether your outlook for the future is bullish or bearish, Metropolitan deserves your consideration.

If you would like to learn more about the Metropolitan Tactical Growth and Tactical Moderate Strategies or any of our other risk-managed AdvisorLink^® investment programs, please feel free to contact us in one of the following ways:

Give us a call at (800) 348-3601 and ask to speak to one of our Investment Consultants;
Send an e-mail requesting information to info@halbertwealth.com;
Visit our website at www.halbertwealth.com and click on the “Contact Us” link at the bottom of the page; or
Click on the following link to access our online information request form.

While the brief discussion in this E-Letter offers a good thumbnail sketch of Metropolitan’s approach to managing money, you can gain a better appreciation of their strategy by hearing David and Sharon themselves explain their methodology. Click on the link below to listen to a recorded webinar that we did with Metropolitan earlier this year:

Metropolitan Capital Strategies Webinar

As always, past performance is not necessarily indicative of future results. Be sure to read all offering materials and Important Disclosures below before making a decision to invest.

Wishing you profits,

Gary D. Halbert

IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM) and Metropolitan Capital Strategies, LLC. (MCS) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. HWM receives compensation from MCS in exchange for introducing client accounts. For more information on HWM or MCS, please consult the respective Form ADV Part II, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

From May 1, 2007 to present, the performance data represents two composites called Tactical Growth Composite and Tactical Moderate Composite. (Prior to January 1, 2009, the composites were named Absolute Return Growth Level II Composite and Absolute Return Moderate Level II.) These returns have been prepared and presented in compliance with Global Investment Performance Standards (GIPS), and verified by Cohen Fund Audit Services for the period from May 1, 2007 through May 31, 2008, and by Ashland Partners & Co., LLP from the period June 1, 2008 forward. To receive a complete list and description of MCS investment composites and/or presentation that adheres to GIPS standards, contact Cheryl Parish at 571-379-8586 or email info@mcsmgr.com. Prior to May 2007, the composites consisted of one account in each program that is related to one of the firm’s principals whose investment objectives and philosophy were similar. Prior to May 1, 2007, the performance numbers are not calculated in compliance with GIPS.

These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Metropolitan Tactical Growth and Moderate Strategies. The signals are generated by the use of proprietary models developed by Metropolitan Capital with the objective of participating in stock markets gains while keeping the level of risk moderate to aggressive. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. ETFs carry their own expenses which are outlined in the ETFs’ prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategies, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Metropolitan Tactical Moderate and Growth Strategies.

In addition, you should be aware that (i) in these programs, your principal is not guaranteed and there are risks involved; (ii) the performance of these programs may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in these programs; (iv) Metropolitan Capital will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) these programs fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

As a benchmark for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends), represents an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of this benchmark may differ materially (more or less) from that of the Metropolitan Tactical Moderate and Growth Strategies since it is an unmanaged Index which cannot be invested in directly. The performance of the S & P 500 Stock Index is not meant to imply that investors should consider an investment in the Metropolitan Tactical Moderate or Growth Strategies, which are actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S&P 500 Stock Index.

All accounts in the composites are charged the rate of fees corresponding to the assets placed under management with MCS. Bundled, tiered fee accounts make up 100% of the composites for all periods beginning May 1, 2007. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. The bundled fees include custody, trading expenses, and other expenses associated with the management of the account. Prior to May 1, 2007, the composites consisted of single non-wrap fee portfolios and these returns have been reduced by transaction costs and by the maximum current fee of 2.2%.

The Tactical Growth program writes covered and uncovered put and call options, coupled with risk management techniques. There are special risks associated with uncovered option writing which may expose an investor to a potentially significant loss, and the strategy may not be suitable for all customers. The potential loss in uncovered call writing is unlimited, and the risks of writing uncovered put options can be substantial. Investors should understand the risks and have sufficient liquid assets to meet margin calls. (Note: The Tactical Moderate Strategy does not use options.)

Returns illustrated are net of the maximum Advisor management fees, custodial fees, underlying ETF or ETN fees, and other expenses. Management fees are deducted quarterly, and are not accrued on a month-by-month basis. Returns do not include the effect of annual IRA fees, if applicable. No adjustment has been made for income tax liability. Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record. Dividends and capital gains have been reinvested. Money market funds and other low risk asset classes are not bank accounts, do not carry deposit insurance, and do involve risk of loss. These programs buy and sell on a short-term basis and clients are expected to incur short-term capital gains and losses. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.