Does investing in leveraged ETFs mean opening Pandora's box? (Part 1 of 8)
Leveraged ETFs have been under scrutiny by various authorities, like the Securities Exchange Commission (or SEC) and Financial Industry Regulatory Authority (or FINRA), over the last few years. The base of the arguments lies is whether leveraged ETFs are suitable for retail investors. Recently, FINRA fined Stifel Nicolaus (SF), a brokerage firm, for unsuitable sales of leveraged and inverse ETFs. Many industry experts, such as Blackrock (BLK) CEO Larry Fink, have expressed concerns over the products. Blackrock, the largest money manager in the world, with $4 trillion in client assets, has in fact said it won’t come up with a leveraged ETF. This series is our attempt to educate our readers about leveraged and inverse ETFs, their structure, and their suitability for retail investors. To start, we’ll cover ETF basics in this part of the series.
What are ETFs?
Exchange-traded funds (or ETFs) are an investment avenue that trades on exchanges and generally seeks to track the performance of an underlying exchange. For example, the SPDR S&P 500 (SPY) is an ETF listed on the NYSEArca exchange that seeks to track the performance of the S&P500 index. SPY uses a market-cap weighting structure, with holdings roughly mirroring the constituents of the S&P500. This reflects in the fact that the top ten holdings of SPY account for 17.68% of the total holdings, comparable to a cumulative weight of 19% for the top ten constituents of the S&P500. SPY has invested in 502 companies, compared to 500 constituents of the S&P500. This shows that the ETF closely tracks the performance of the underlying index.
Types of ETFs
While SPY is an example of an ETF tracking a market index, there are numerous types of ETFs based on the sectors and asset classes they invest in, the styles they follow, and their approach to investing.
The SPDR Financial Select Sector Fund (XLF) is an example of a sector ETF. XLF invests in banking, financial services, and insurance companies, with top holdings in Wells Fargo & Co, Berkshire Hathaway, and JPMorgan Chase.
The SPDR S&P 500 (SPY) is an example of an ETF investing in a particular asset class (equities, in this case), while the PowerShares QQQ Trust, Series 1 (QQQ) invests only in non-financial large cap companies, an example of a style-based ETF. The PowerShares QQQ Trust, Series 1 (QQQ), invests in the 100 largest NASDAQ-listed non-financial companies, including Apple, Google, and Microsoft.
Lastly, we can classify ETFs by the approach they follow towards investing. Some ETFs, such as the SPDR S&P 500 (SPY), are passively managed ETFs, where rebalancing the portfolio happens sparingly. Some ETFs shuffle their portfolio more frequently and don’t follow any index. These kinds of ETFs are known as “actively managed portfolios.”
We’ll compare actively managed and passively managed ETFs in the next part of this series.
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