More Tips About Investing

The original, stock-based exchange traded funds (ETFs) were a breakthrough financial product. They make great substitutes for traditional mutual funds because they trade all day like stocks, have a low cost, and are much more tax efficient.

Today, however, there are many new, exotic ETFs coming out. For the most part, these products should be avoided:

1. Leveraged ETFs – Normal funds that replicate an index or its reverse are fine products. The problem comes in when people buy the new wave of leveraged ones which duplicate 2 or 3 times the underlying index (or its reverse). They don’t understand that these products are meant for day trading, and thus replicate 2 or 3 times the daily movement of the index. This makes them unsuitable for long term, buy and hold investing.

For example, if a certain index is down 10% for the year, a fund that replicates 2 times the index might be down 24% – not down 20%. Perhaps even more confusing, an ETF that replicates 2 times the reverse (which might be expected to return +20%) might be down 16% for the year. Again, this is because the funds are designed to double the daily volatility.

2. Lack of Liquidity – Some of the new ETFs suffer from too narrow a focus. This makes them vulnerable to lack of liquidity and stray from their intended purpose. For example, the United States Oil Fund tracks oil futures, but under performs the market due to slippage, since it is a very thin market. The First Trust Global Wind Energy ETF is supposed to invest only in clean energy. However, since there are only a small number of wind energy companies, the fund has to invest in companies like BP.

3. Tax inefficiency – Some exchange traded funds that invest in metals – such as the SPDR Gold Shares and iShares Silver Trust – are structured as grantor trusts. This results in investors paying taxes at ordinary income levels – rather than at capital gains rates.

Over the years, Praveen Puri, a trading and financial veteran, developed a passion for simplicity, minimalism, and Eastern philosophy. He developed a pure Zen trading system. It uses no news reports, indicators, charts, or parameters to distract you from Now. They are nothing but crutches that keep you hobbling around, instead of surfing in flow with the market.