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The last few years have seen Exchange Traded Funds or ETFs, become exceptionally popular, especially in the United States. This popularity is well justified as ETFs offer an easy way of gaining exposure to stock groups and commodities.
Broad market and industry group based funds attract the most volume, but there are also ETFs on currencies, a wide range of other commodities and even short positions. This makes matching an index like the S&P 500, hedging currency risk or profiting from a falling market far more accessible - and cheaper - for the average investor than ever before.
A good example is the iShares FTSE/Xinhua China ETF. This matches the movement of the top 25 Chinese shares and can be traded in the US via the symbol FXI (NYSE) or in Australia through IZZ (ASX). The FXI is currently up 97.5% from its March low, outperforming the SPX which is up 66%.
US FTSE China ETF vs. S&P 500
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However, as with any financial instrument or investment, it is vital that investors do their homework before diving in. In Australia, one consideration for ETFs is dividends and more importantly, if the dividends are franked. For those unfamiliar with franking credits, the ASX website defines a fully franked dividend as:
“Dividend paid by a company out of profits on which the company has already paid tax. The investor is entitled to an imputation credit, or reduction in the amount of income tax that must be paid, up to the amount of tax already paid by the company.” www.asx.com.au
Franking credits are part of the dividend imputation system and both avoid the double taxation of company profits and offer a tax incentive to invest in shares.
Checking the specifications of the IZZ (ASX) ETF reveals that the dividends are not franked. While not a show stopper, this could make a significant difference at tax time and therefore should be understood in advance.
Of more concern is the way that some ETFs are calculated. Take the Ultra-short Oil & Gas ETF (DUG:NYSE). As the word ‘short’ suggests, the DUG is designed to move inverse to the Oil & Gas sector. Not only that, ‘ultra’ means it will move twice the distance in the opposite direction, or will it?
The chart below shows the Oil & Gas Index (DJUSEN: CBOT) compared to the DXD. Note that in 2008, while the DJUSEN made a lower low in November than in October, the ‘ultra-short’ DUG failed to make a higher high.
Ultra-Short Oil & Gas ETF vs. Oil & Gas Sector Index
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This can be taken a step further by introducing the Ultra (long) Oil & Gas ETF (DIG:NYSE) which is designed to give double the long exposure. Now, one would quite naturally expect that if you bought both the DIG and DUG on the same day, you would be perfectly hedged (obviously this would not be done in practice) and therefore whatever loss was made on one leg would be balanced out by an equal sized profit on the other leg. Not the case! Buying both on October 10th 2008 could have resulted in a loss on both positions as the chart shows.
Ultra Oil & Gas vs. Ultra-short Oil & Gas
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Essentially, the reason for this abnormality is the method used to calculate the movement of ETFs. So the simple solution is always to check the performance of an ETF to see what it is based on. This can be done easily in products like ProfitSource via the overlay feature used in the charts above. One instrument can even be inverted when comparing short ETFs.
There are also indicators like Relative Strength Comparison that will compare the performance of one symbol to another. If a symbol is exactly correlated to the comparison symbol, the RSC will have a value of 100. The chart below illustrates just how well correlated the SPY (S&P 500) ETF is to the S&P 500 Index.
S&P 500 ETF vs. S&P 500 Index
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An ETF with the kind of correlation above, makes for a very simple way to match the performance of an index – the goal of many fund managers – at a low cost when compared to other alternatives.
All-in-all, exchange traded funds are very useful. However, like anything, it is important to understand what you are trading.
Happy Trading
Jordan Craw
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