There are pitfalls to Exchange Traded Funds in their plain vanilla form or the ones now with many more bells and whistles. In answer to some inquiries, I'll delve into key risks of using them and then look at how they can be useful in my part 2 follow up piece. I start with the 'bad news' first so to speak and then move on to the 'good' or beneficial aspects of financial instruments put together by the creation geniuses of the Street of Dreams.

MUTUAL FUNDS STARTED A TREND:

Traditional, actively managed mutual funds usually begins with investors having cash to put in the Market which attracts people who have expertise in picking and managing stocks in the case of actively managed funds; versus no-brainer index funds.

Of course most of the active manager types do not outperform the S&P 500 (SPX) over time, hence the huge amount of money in index funds. Most index funds are in fact mostly computer-driven as the process is simply to replicate the underlying SPX. A result is that the so-called expense ratio of index funds are quite low. This is also true of Exchanged Traded Funds (EFTs) that you can buy or sell any time during daily trading hours for stocks and not just at the end of the day at the Net Asset Value (NAV) of a mutual fund. Since I'm talking here about EFT's, here's a list of some low expense ETFs.

Now the above is not the FULL picture because there is now a fair proliferation of ETFs that are actively managed also and also use the leverage involved in futures and options to attempt to magnify moves in the stock market or in ones that trade oil or natural gas for example. This costs more. The average of the expense ratios of all ETF's that includes the actively managed ones with more expenses, is closer to .44%.

If a mutual fund is popular or its salespeople make it so (yes, I've done that!) it attracts lots of money. The more money that comes in, the more fund shares must be created, and the more stocks investment managers must go out and buy more for the fund.

EXCHANGE TRADED FUNDS (ETFs)

ETFs work almost in reverse. They begin with an idea such as tracking the S&P or Dow and use the fact that major investing institutions like Fidelity or the Vanguard Group already control billions of shares in the big stock indices.

To create an ETF, they can easily put millions of these shares to use and put together a basket of stocks to represent the appropriate index; e.g., the Nasdaq composite (COMP) or the stocks in the S&P 500 (SPX) and 100 (OEX).

These big institutions deposit the shares with a holder and receive a number of what are called 'creation units' in return. They basically trade stocks for these creation units and in effect create a fund using stocks instead of cash. Note the reverse concept as the mutual fund starts with cash and has to pay to buy the shares and manage them; e.g., research costs money.

A creation unit is a block of 50,000 or more shares of the ETF. These creation units are then split up by the recipients into the individual ETF shares that are traded on an exchange. More creation units (and more ETF shares) can be made if institutional investors deposit more shares into the underlying structure. I should note too that a pool of outstanding ETF shares can diminish if one of the big institutions swap back creation units for underlying shares in the basket.

ETF strategies are plentiful, but so are the pitfalls. Most of the downside tends to be self-induced, especially excessive trading. A painful lesson can also occur by the misguided purchase of an ETF. Aside from the obvious risk of the securities in your ETF dropping in value, in the most common ETFs, which match an index or particular commodity price, some risks can be managed with discretion and trading temperance on your part.

TWO MAJOR RISKS THAT HAVE TO DO (ONLY) WITH YOU!

1. Buying an ETF without understanding what it's based on. 2. NOT watching your brokerage costs.

OTHER RISKS AND CONSIDERATIONS IN ETFs:

Too much concentration: If you're already holding a bunch of tech stocks, a tech-oriented fund may be too much exposure to Technology stocks. Moreover, as actively managed ETFs proliferate, an ETF based on a general criteria like 'growth' can end up with certain sector overkill when you may want a more balanced portfolio.

ACTIVELY MANAGED ETFs

Actively managed ETFs are somewhat recent in the U.S. I understand that the first one got launched in March 2008 but didn't trade for long. The actively managed ETFs approved to date are fully transparent, publishing their current securities portfolios on their web sites daily.

The fully transparent nature of existing ETFs means that an actively managed ETF is at risk from arbitrage activities by market participants who might choose to front run its trades. The initial actively traded equity ETFs have addressed this problem by trading only weekly or monthly. Today however, actively managed ETFs trade at the discretion of the manager and we don't hear much about front-running.

Actively managed ETFs have grown faster in their first three years of existence than index ETFs did in their first three years of existence. However, as track records develop, actively managed ETFs will increasingly compete with actively managed mutual funds. There are a number of factors involving actively managed Exchange Traded Funds that need to be considered:

Commodity ETFs like the United States Oil Fund (USO) and the US Natural Gas fund (UNG) have futures roll over risk. They actually decline in value every futures cycle because of the cost of rolling to the next month.

What are known as Inverse ETFs carry definite risks. 2X and 3X leveraged ETFs have an implied cost because they use options and/or futures to develop the leverage. As those options/futures expire the ETF does bleed some value. More on 2 and 3X ETF's coming up; i.e., bull or bear ETF's that attempt to outperform by 200 to 300% the underlying moves in the S&P for example. This brings in transaction costs, commissions, management fees and so on.

INVERSE EXCHANGE-TRADED FUNDS

An inverse exchange-traded fund is an exchange-traded fund (ETF), traded on a public exchange like the American Stock Exchange or Nasdaq, which is designed to perform as the inverse of whatever index or benchmark it is designed to track.

These funds work by using shorting, using derivatives such as SPX futures contracts and other leveraged investment techniques. Over short investing horizons and excluding the impact of fees and other costs, performance opposite to their benchmark, inverse ETFs are intended to give a result similar to shorting the stocks in the index.

An inverse S&P 500 ETF, for example, seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%. Because their value rises in a declining market environment, these funds can be popular in bear markets, especially as a portfolio hedge.

Shorting has the potential to expose you to sharp losses, whether or not the sale involves a stock or ETF. Yes, you can short ETFs. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. But, that's true of put options too.

LEVERAGED ETFs

Leveraged ETFs are a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. Leveraged index ETFs are most often marketed as Bull or Bear ETFs.

A leveraged bull ETF fund might present itself as attempting to achieve daily returns that are twice or three times (2X or 3X) greater than an underlying index like the Dow 30 Average (INDU) or the S&P 500.

In the same way, a leveraged inverse (Bear) ETF fund attempts to achieve positive gains that are two or three times more than a daily decline in the underlying index or instrument; i.e., the Bear 2X or 3X ETF is structured in an attempt to GAIN double or triple the amount of a daily loss.

Leveraged ETFs require the use of financial engineering techniques, including the use of equity swaps, derivatives and rebalancing, and re-indexing to achieve the desired return. The most common way to construct leveraged ETFs is by trading futures contracts.

The rebalancing and re-indexing of leveraged ETFs will have more costs when markets are volatile. The rebalancing problem is that the fund manager incurs trading losses because he needs to buy when the index goes up and sell when the index goes down in order to maintain a fixed leverage ratio.

A 2.5% daily change in the index will for example reduce value of a -2X bear fund by about 0.18% per day, which means that about a third of the fund may be wasted in trading losses within a year. A reasonable estimate of daily market changes is 0.5%, which leads to a 2.6% yearly loss of principal in a 3x leveraged fund.

The re-indexing problem of leveraged ETFs stems from the arithmetic effect of volatility of the underlying index.

EXAMPLE: An index begins at 100 and a 2X fund based on that index that also starts at 100. In a first daily trading period to use a number easy to follow, the index rises 10% to 110. The 2X fund will theoretically then rise 20% to 120. The index then drops back to 100 (a drop of 9.09%), so that it is now even. The drop in the 2X fund will be 18.18% (2 times 9.09). 18.18% of 120 is 21.82. This puts the value of the 2X fund at 98.18.

Even though the index is unchanged after two trading periods, an investor in the 2X fund would have lost 1.82%. This decline in value can be even greater for inverse funds (leveraged funds with negative multipliers such as -2, or -3). It always occurs when the change in value of the underlying index changes direction. And the decay in value increases with volatility of the underlying index.

MORE ON LEVERAGED ETF's

Leveraged Exchange Traded Funds are especially built to trade like stocks and to trade moves in an index minute-by-minute or in my more slowed down life, hour by hour. That's particularly true with ETFs using leverage, where complicated margin and options strategies magnify the performance of an underlying index.

No matter the flavor, leveraged ETFs are trading vehicles, providing daily exposure to the index; they are built as if they will be held for a SINGLE day. Their promise of tracking an underlying index is simply a series of one-day events. As a result, compounding and other factors make it so that leveraged ETFs can veer off course when examined over longer periods.

As to comparing the daily range of highly leveraged ETF's it is unfair to compare funds in the same asset classes trading on an un-leveraged basis. The typical fund would be hard to judge in a day, while the leveraged ETF gets blurry over time, making for apples-to-oranges comparisons. Still, average traders can get attracted to leveraged ETFs based on hot performance over short windows and they can wind up in an trading trap because they looked for 'more action'.

COMMISSIONS & FUND FEES

Fees can take a big bite out of your returns, so low ETF expense ratios are one way to predict better performance, since you keep more of your gains. ETF commissions from online or discount brokers can range from $0 for purchase on up to 10 to $20 from full-service brokers.

Fidelity for example will charge you nothing for some 65 iShares, including the 10 iShares 'core' ETF's plus some others. Another 1400 can be bought or sold for around $8 (7.95). Effective this July however, iShares ETFs purchased commission free must be held for a minimum of 30 calendar days or a short-term trading fee will apply.

If you trade in or out of an ETF several times a day, those $8 or greater commissions can take a big bite out of any profits, especially when trading for small price swings.

EXAMPLES OF PRICE SWINGS IN A 3X S&P ETF, BOTH BULL AND BEAR

Direxion offers a diverse set of leveraged and inverse funds that they indicate should be used by hands-on active traders looking to execute short-term trading strategies. I would say yes, they should only be used by active traders. Two actively traded ETF's from Direxion are the:

Direxion Daily S&P 500 Bull 3X Shares ETF; Symbol: SPXL

Direxion Daily S&P 500 Bear 3X Shares ETF; Symbol: SPXS

The leveraged ETFs listed above are generally used by shorter-term traders as far as individual participation and not 'buy and hold' investment types. Each of the two leveraged funds (SPXL and SPXS) indicates an expense ratio of approximately 1%. This versus an average of all ETFs, which includes actively managed ETFs, of around 0.44%.

I found it useful today (5/1/13) to see if a 3X Bear ETF share price came near to meeting its objective of increasing by 300%. Here is my back of the envelope calculations in comparing today's decline of close to 1 percent in SPX as to the price swings in SPXL (the Direxion Bull 3X ETF) and SPXS (the Direxion Bear 3X ETF). You can short ETFs and it does not require a prior up tick to so, unlike stocks.

Direxion, the ETF manager involved in my survey of their 3X Bull and Bear funds states that: "Leveraged and inverse exchange traded products are not designed for buy and hold Investors or investors who do not intend to manage their investment on a daily basis. These products require a Most Aggressive investment objective and an executed Designated Investments Agreement to purchase. These products are for sophisticated investors who understand their risks (including the effect of daily compounding of leveraged investment results), and who intend to actively monitor and manage their investments on a daily basis."

In other words, CORRECT MARKET TIMING IS AS IMPORTANT as in many if not most options strategies. With the leverage of these ETFs you are at risk of magnified price swings.

Today the aforementioned Direxion Daily S&P 500 Bull 3X Shares ETF fell from a high of 40.7 to a low of 39.7, for a price swing of 2.4%, versus an SPX decline of around 1% from its daily peak (1597) to trough (1581).

How did the Direxion Daily S&P 500 Bear 3X Shares ETF (SPXS) fare today (5/1/13) with SPX down .93 percent? SPXS went from an Open of 11.5 to a Close of 11.7, for a gain of 1.7%, not quite a double even. I don't pretend that this 1-day sample is a fair assessment of this Bear 3X fund week in and week out but I found it of interest for illustration purposes.

Please E-MAIL me with your experiences in being an active ETF trader or with thoughts on their use.

I'll continue on ETF's in a soon to follow article which will describe more on the Exchange Traded Fund universe out there and the benefits of using ETFs, such as by playing the 9 Sector sub-indices of the S&P 500. A snapshot from yesterday (4/30/13) shows the 2 year performance of the 9 SPX sectors.

You might imagine or have built a superior performing S&P by excluding sector ETF's that you assessed as having less potential in the economy we've had in the past couple of years!

TWO YEAR S&P 500 SECTOR PERFORMANCE

The SPDR S&P 500 (SPY) gained 10.3% in the 2 years ending 4/30/13.

Health Care Select Sector SPDR (XLV): + 17.9% E.g., JNJ, PFE, MRK

Consumer Discretionary Select Sector SPDR (XLY): + 17.4% E.g., DIS, MCD, AMZN

Consumer Staples Select Sector SPDR (XLP): + 17.1% E.g., PG, WMT, CVS

Utilities Select Sector SPDR (XLU): + 15.2% E.g., DUK, SO, D

Financial Select Sector SPDR (XLF): + 8.7% E.g., JPM, WFC, BAC, C;

Technology Select Sector SPDR (XLK): + 8.5% E.g., AAPL, MSFT, GOOG;

Industrial Select Sector SPDR (XLI): + 5.7% E.g., GE, UTX, MMM;

Energy Select Sector SPDR (XLE): + .6% E.g., XOM, CVX, SLB

Materials Select Sector SPDR (XLF): + 0.7% E.g., DD, DOW, FCX;


GOOD TRADING SUCCESS!