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Make sure you understand how your ETF works

by , 26 August 2013

ETFs are a very useful type of passive fund. But you need to make sure you know exactly how the ETF you're investing in works before you invest. Read on to find out what you need to know about ETFs…

Since launching in South Africa, ETFs have been very successful. And the number available to invest in is growing.

But as the market grows, the products become more complicated, John Stepek explains in MoneyWeek.

Exchange traded commodities are an example of this. Funds that track the gold price for instance are much more transparent than funds that trade commodities like oil and corn prices. These funds are much more complex.

There is also another type of ETF that you should be wary of…

The dangers of ‘short’ and ‘leveraged’ ETFs

These funds aren’t currently available to trade in SA, but you could invest in them through an overseas broker.

‘Short’ ETFs offer you the chance to bet on a market falling. They promise to offer the ‘inverse’ return on an index. In other words, when the index falls, the ETF rises, and vice versa.

‘Leveraged’ ETFs offer to give you twice or even three times the return on a given index. So if the index rises by 5% in a day, you’d expect the ETF to go up by 15%.

You can even get ‘short leveraged’ ETFs, that offer, say, double the inverse return on an index. So if the index falls by 5% in a day, such an ETF would go up by 10%.

This all sounds great, particularly if you think a market is going to fall. But the trouble is, these ETFs may not do what you expect them to.

The key problem is that the fund managers rebalance the ETF daily. In short, that means that if you hold them for more than a day, they start to drift away from the performance of the underlying index.

Example of a leveraged ETF

Here’s an example to show you how it works. Say an index rises by 10% over one day, from 100 to 110. A two-times leveraged ETF based on the index would rise by 20%, from 100 to 120. So far, so good.

On day two, the index falls by 5%, from 110 to 104.5. The double-leveraged ETF falls by 10%. That takes the ETF from 120 to 108.  

So after two days, the index has risen from 100 to 104.5. That’s a gain of 4.5%. So you might expect the double-leveraged ETF to have risen by 9%. But it hasn’t. It’s gone from 100 to 108, which is a gain of 8%.

That’s after just two days. Think of the potential drift after a month.

The more leverage an ETF uses, the worse the drift will be. But even simple ‘short’ ETFs will drift over time.

So while these products might be useful for short-term traders, they certainly aren’t for beginners, or for investors who want to make a long-term bet on a market falling.

The golden rule of investing in ETFs

A lot of these products are only suitable for people who really understand the bet they’re taking.

If you just look at the name of the ETF and make assumptions about how it works, you’re likely to be disappointed.

Bottom line: If you don’t understand it, don’t invest in it!

Make sure you understand how your ETF works
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