Market Storm: A Good Trial for New ETFs

09/06/2011 7:30 am EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

The recent stock-market decline allows investors to weigh how these exchange traded funds are performing, writes Rob Carrick, reporter and columnist for The Globe and Mail.

"New" is a word that should be a big turnoff when evaluating investment products.

Financial companies have a way of making new products sound like the answer to your problems. But until you’ve seen how these products weather a rough period in the markets, you really don’t know what you’re buying.

In a previous column, I suggested that you shouldn’t buy an investment product without checking its performance in 2008, a historically bad year. Now, we have this summer’s stock-market decline to use as a much-smaller-scale but still noteworthy stress test for some new exchange traded funds that weren’t around back in ’08.

The ETF industry has been prolific in the past year or so in releasing innovative products that go beyond the traditional mandate of delivering the returns of major stock and bond indexes, minus a small fee.

There are new ETFs that let you profit from the kind of stock-market volatility we’ve seen lately, or that pay vastly more income than you can get from traditional bonds and term deposits, or that offer exposure to various types of commodities.

Let’s see how these ETFs met the challenge posed by the market declines last month, starting with the HBP S&P 500 VIX Short-Term Futures ETF (Toronto: HUV). Introduced late last year, HUV was a juggernaut in August that racked up a gain of 68% while the S&P/TSX composite and S&P 500 indexes fell 1.4% and 5.7%, respectively.

HUV tracks the S&P 500 VIX Short-Term Futures Index, which is designed to reflect investor sentiments about short-term stock market volatility. This index soared in August, and so did HUV.

Tempted to get some of this ETF to protect against future market lapses? Think twice, because HUV is too wild a ride for the average individual investor.

You can see this in the fact that its gain for the year through August 31 was just 7.3%. In fact, HUV was actually down for the better part of the past year, only surging higher when the market tanked in August.

This warning about HUV goes double for its leveraged twin, which goes by the ticker symbol HVU (leveraged means it gives you twice the up or down move of the target index).

Another option for tracking the S&P 500 VIX Short-Term Futures Index is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). This is an exchange traded note (ETN), which is an ETF cousin with some characteristics of bonds.

Basically, banks issue ETNs with the promise of paying you the returns of the underlying index. VXX has been issued by Barclays Bank PLC, and it made 71.3% in August.

The most popular of the new ETFs in the Canadian market are those based on covered call writing, a strategy of generating high levels of income by holding stocks and selling call options on them. Investors buy call options to have the opportunity of buying a stock at a preset price and time.

Covered call ETFs haven’t been around a full year yet, but their monthly income payments so far suggest annualized yields in the range of 10% to 18%. High income is nice, but many investors get nervous if the price of their investments is sinking even as the monthly income payments roll in.

The most diversified of the covered call ETFs is the HAP Enhanced Income Equity ETF (Toronto: HEX), which is based on a portfolio of 30 equally weighted blue-chip stocks.

HEX was down 3.3% in August, more than double the decline of the S&P/TSX composite index. But on a total return basis, income payments as well as share price changes, HEX was down just 1.2%.

The most popular covered call ETF, as judged by daily trading volumes, is the BMO Covered Call Canadian Banks ETF (Toronto: ZWB), which fell 0.6% in price last month, but had a total return of 0.2%.

The message for investors is that covered call ETFs will fall in down markets, but the income they pay can take at least some of the edge off.

One new product from the Claymore family of ETFs has done conspicuously well lately, while another has done just the opposite. On the plus side, we have the Claymore Broad Commodity ETF (Toronto: CBR), which tracks an index of futures contracts on 12 different commodities in the energy, agriculture, and metals sectors.

Many commodities have fallen hard in price lately, but CBR managed to gain 1% in August and 6.8% for the year through August 31. The S&P/TSX composite index fell 5% for the first eight months of the year.

Claymore explains CBR’s resilience as being a result of risk controls that can reduce exposure to zero in a commodity that is plunging in price. Lately, CBR’s portfolio has been only 44% invested in commodities, with the rest in cash.

CBR could certainly lose money in another big market decline, but it bears watching as a way of cutting the substantial risks of commodity investing.

Claymore’s Advantaged Short Duration High Income ETF (Toronto: CSD) hasn’t held up as well lately. CSD is designed to provide investors with the extra-large yields available from high-yield bonds, while reducing risk by holding only bonds that will be redeemed in a year at most.

A couple of points of explanation are required here. First, high-yield bonds are issued by non blue-chip companies that have to pay extra-juicy interest rates to attract investors. Second, risk in holding all kinds of bonds declines the closer you get to maturity. In other words, shorter terms are safer.

CSD yields roughly 5% these days, so you’ll definitely generate more income than you would with government and high-grade corporate bonds. The cost is a higher risk profile that in August resulted in a 3.3% decline in price.

Claymore says its goal with CSD is to provide a positive return over a 12-month period. But the results of the August stress test suggest the ride for investors can turn nasty in a sudden stock-market plunge.

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