Stay Away from These Toxic ETFs

10/25/2011 3:55 pm EST

Focus: ETFS

Matt Hougan

CEO, Inside ETFs

Many of the new inverse and leveraged ETFs coming out now are not for most investors, says ETF expert Matt Hougan of in this exclusive interview with

We’re talking about toxic ETFs with Matt Hougan. Hi Matt, you have your hazmat suit on today?

I guess I should get it on.

So, we’ve seen…you’ve followed ETFs, you’ve covered ETFs. I invest heavily in ETFs, as well as some mutual funds. It’s been amazing how this sector has developed. It’s been overwhelmingly a “good thing” for investors. Right, and then the trillions of dollars of money has shown that.

However, not all these ETFs are always good, some of them are not really good for people at all, are they?

Well they’re not good for long-term investors. It comes down to understanding how these products work.

Some of them are not good for the long-term.

Exactly, exactly. The classic case are leveraged and inverse funds. These funds are enormously popular right now. They promise…

Could you explain very quickly what they are?

Sure. Well, they promise to deliver, say, 200% or negative 200% of the return of an index, so you would have one tracking say the S&P 500, but when the S&P 500 goes up 1% it will go up 2%. That’s attractive to people.

Or if it’s a negative inverse two times, it will go down 2% for every 1% point the S&P goes up.

That’s exactly right. That sounds great, and it is great for short-term traders.

The problem is, people make the assumption that if I buy it today and the S&P 500 goes up 10% over the next year, that fund is going to be up 20% or down 20% depending on which side you’re on, and that’s absolutely not true. Over the long-term in volatile markets, these funds will consistently lose money due to compounding in the returns.

OK. So in other words, they get so deep in a hole that in order to get back to where they should be, it’s coming from a lower base, so it’s much hard for them to do.

That’s exactly right, it just multiplies. We can walk through the math if you want.

I think people kind of understand the concept. But I’d like to get, I mean repeatedly even the SEC and others have said that these things are not suitable for most people and are only really to be held for a day or so.

A day or a few days, that’s absolutely right.

Think, when you are in your E-Trade account or your Schwab account, you can’t automatically use options. Right, you have to be qualified and cleared and fill out those forms.

These are delivering the same essential idea of leveraged exposure, but you can buy these simply and easily. I think people just, they don’t necessarily understand how they work and they can get into trouble.

The same thing is true in the commodity space, for different reasons. In something like volatility products, what you are buying is not always what you think you’re buying.

So a volatility product is you can buy an ETF based on the VIX index.

That’s right, but you’re not going to track the VIX index at all, because it’s actually based on futures dated out two months…and that has a very different pattern of returns than spot VIX.

How about something like put options or call options, or writing puts or selling calls, or whatever using ETFs, you can do that of course.

Oh, absolutely, and those can be great strategies. You can develop a nice buy-write strategy on an ETF.

That’s selling calls, right?

Exactly, against a held position. That de-risks the position, and you get a nice income stream. Those can be great tools.

Those markets are extraordinarily liquid. If you know how to do it, it’s a great product.

If you know how to do it…you have to educate yourself.

If you know how to do it, exactly. That’s the big lift.

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