ETFDangers

&

How ToConquer

ThemRon Rowland

InvestWithAnEdge.comAustin, Texas

HoustonInvestors

Association1/19/13

Ron Rowland

President, Capital Cities Asset Management Investment Management Services

Editor, AllStarInvestor.com Publisher of subscription newsletters

Founder, InvestWithAnEdge.com ETF analysis and market commentary

ETF Dangers & How to Avoid Them

1) Liquidity Dangers

2) Execution Dangers

3) Structure Dangers

Q & A

The ETF 92-8 Rule

80-20 Rule: “80% of results are from 20% of the activity”

For ETFs/ETNs: 92% of $ Volume is from just 8% of funds

36.4% SPY SPDR S&P 500

5.5% IWM iShares Russell 2000

4.7% QQQQ PowerShares QQQ

3.7% EEM iShares MSCI Emerging Markets

2.9% GLD SPDR Gold Trust

The top 8% (~115) are also referred to as “the vital few”

8

58

289

467

369

169

61

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500< $

1k

$1k -

$10k

$10k -

$100k

$100k

- $1 M

$1 M

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$10 M

$10M

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$100M

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- $1 B

$1 B

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10B

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ETF Liquidity Tiers4Q-2012 ADVT

Deathwatch

$ Billion Club

The Vital Few

What Makes an ETF an ETF?

ETFs are unique: not mutual funds, not closed-end funds, not stocks

The ability to create and redeem shares via in-kind exchange is key to the operation of an ETF

The in-kind exchange process allows the price to track the NAV through arbitration

If price < NAV: sell stock & buy ETF sharesIf price > NAV: buy stock & sell ETF shares

Liquidity Liquidity DangersDangers

1) B/A Spreads

2) ADVT ($ Volume)

3) Underlying Markets

B/A spreads have both an “advertised spread” and a supported or “liquidity spread”.

Example: RSX Depth Screen shot – next slide

1) Do not accept B/A spreads at face value. Look at B/A depth.

2) Use limit orders.

DANGER

SOLUTION

Example of Misleading Bid/Ask SpreadAdvertised B/A = 44.31/44.35 .04Supported B/A = 44.18/44.48 .30

B/A spreads are often very wide when the market opens and sometimes just before close.

Example: iShares Nasdaq Biotech (IBB) B=83.03 A=84.35 1.32 (at open) B=83.75 A=84.27 .52 (1 min later) B=82.20 A=82.24 .04 (mid-day)1) Do not use “Market on

Open” or “Market on Close” orders.

2) Wait until B/A spread is being managed

DANGER

SOLUTION

DANGER

SOLUTION

B/A spreads are often at ridiculous values during after-hours trading.

Example: iShares DJ US Medical Devices (IHI) B=58.99 A =67.39 Spread = 8.40

1) Do not trade ETFs after-hours.

2) If you must trade after-hours, then always use a limit order.

Some ETFs can go for days without any trades occurring. You may not be able to sell your position in a timely manner.

1) Do not trade ETFs that are on our ETF Deathwatch list.

2) Trade only 100 shares and be willing to accept the B/A spread.

DANGER

SOLUTION

ETF liquidity is a function of the liquidity of the underlying stocks.

Even thinly traded U.S. ETFs may have better liquidity than higher volume international ETFs.1) Trade European ETFs in the

morning for best liquidity

2) Remember that there is no overlap with Asian markets

DANGER

SOLUTION

1) Market Orders

2) Stop-Loss Orders

3) Transaction Costs

Execution Execution DangersDangers

Do not use “market orders” on transactions that are larger than the advertised number of shares at the B/A spread.

Example: PHO screen shot – next slide

1) Use limit orders.

2) Only use market orders on the most liquid and high volume ETFs.

DANGER

SOLUTION

Example of“Buy at Market”

Market on Open orders andMarket on Close orders may not have the desired effect.

Example: The B/A spread is wide at the open/close The “open” is unmanaged for most ETFs.

1) Do not use “Market on Open” or “Market on Close” orders.

2) Use limit order if trading near the open or close.

DANGER

SOLUTION

Example of“Market on Close”

XLP close at 24.1511/06/08

Avoid “stop-loss” orders, especially on thinly traded and international ETFs. Overnight gaps are often exaggerated.

1) Use “mental” stop-loss or computer alerts.

2) Place orders manually.

DANGER

SOLUTION

Flash Crash – May 6, 2010Another reason to not use stop-loss orders

1) Tracking

2) Leverage

3) ETNs

Structure Structure DangersDangers

ETFs may not track what you think they should track.

Example: Crude-oil ETFs 3/30/07–8/31/07 +12.4% spot price change for WTI crude +7.9% MacroShares Up Crude Oil (UCR) +5.5% iPath S&P GSCI Crude Oil (OIL) +4.6% United States Oil Fund (USO) -1.9% PowerShares DB Oil (DBO)

1) Look beyond the name of the ETF to see if futures used.

2) Avoid future-based ETFs when underlying in contango.

3) Use for day-trading in non-roll weeks.

DANGER

SOLUTION

Hypothetical Contango ExampleContango occurs when next contract costs more than expiring contract.

ETF based on futureswith monthly contract rollwhile in contango

Spot Price Index

ETFs may not track their index.

Example: In late 2007, the securities regulator of India placed a halt on purchases by foreign investors.

iPath MSCI India ETN (INP) was trading at a +15% premium to the indicative value. It had essentially become a closed-end fund. Compare the ETF’s trading

price to its Indicative Value. The IV symbol typically uses the following format:

$INP.IV (for INP on eSignal)

^INP.IV (for INP on Yahoo)

DANGER

SOLUTION

Indicative Value is meaningless when the underlying market is closed.

Example: iShares S&P Europe 350 (IEV) Price closely tracks IV while Europe open Price deviates from IV once Europe closes

1) Trade European ETFs in the morning for best liquidity & tracking

2) Remember: there is no overlap of US and Asian markets

DANGER

SOLUTION

Indicative Value whenunderlying mkt closed

Leveraged and Inverse ETFs may not perform the way you think they should over periods longer than a day.

Example: DirexionShares 3x Financials Bull (FAS) and 3x Financials Bear (FAZ) can both go down in value

1) Do not buy leveraged or inverse ETFs unless you fully understand how they work

2) Have an exit plan

DANGER

SOLUTION

Some equity and commodity ETPs contain credit risk.

Example: ETNs – Exchange Traded Notes are essentially bonds that are linked to an equity, commodity, or other index. You are therefore at risk of issuer default.

1) Favor ETFs over ETNs 2) Only buy ETNs based on

issuer names you can trust. 3) A default would likely put

them out of business. Should not happen overnight.

DANGER

SOLUTION

ETNs – Exchange Traded Notes are essentially bonds that are linked to an equity, commodity, or other index. You are therefore at risk of issuer default.

DANGER

Three ETNs were backed by the full faith and credit of Lehman Brothers (bankruptcy): - Opta S&P Private Equity Notes ETN (PPE) - Opta Lehman Agriculture Pure Beta ETN (EOH) - Opta Lehman Commodity Index ETN (RAW)

SOLUTION Know the bond issuer and monitor its financial health

Sometimes the marketing material doesn’t tell the whole story.

Examples:

Understand what you are buying

DANGER

SOLUTION

UBS Gold-Hedged S&P (SPGH) – says half in gold & half in S&P. Leaves out that each half is 100% and that it is a 200% leveraged fund.

Alerian MLP ETF (AMLP) – says will track index minus expenses. Leaves out that 37.5% of gains withheld for the fund’s corporate taxes are part of the total expenses.

1) Tracking

2) Fees

3) No liquidation

Closure DangersClosure Dangers

What to do if your ETF closes

ETFETFDeathwatchDeathwatch

MacroShares Major Metro Housing Up/Down charged shareholders early termination fees

$0.85 - $0.90 per share (~ 3.5% of share value)

Annualized expense ratio for UMM/DMM > 12.5%

Sell Immediately toAvoid Termination Fees

• Some funds begin liquidation immediately upon closure announcement

• Fund will not be able to track its objective (target index) during this period

• You don’t really know what you own

Example: On 7/23/2009, XShares announced intentions to close the AirShares EU Carbon Allowance Fund (ASO) effective July 31, 2009 and that liquidation would begin immediately.

Sell Immediately toAvoid Tracking Error

Funds may choose to delist but not liquidateCreation/redemption process removedNo active bid/askYour shares are stuck in limbo

3 Credit Suisse ETNs now trade OTC Elements MLCX Gold Index ETN Elements MLCX Livestock Index ETN Elements MLCX Precious Metals Index ETN

Sell Immediately to Avoid Non-Redemption

The liquidation/redemption process usually takes 3-5 days, but there is no guarantee

You might save a transaction fee but: Your money will not be invested You will not have access to your money

You will be unable to take advantage of other opportunities

Sell Immediately toAvoid Opportunity Risk

If a fund you own announces a closure:

1. Determine fair value (indicative value ticker)

2. Sell shares with a “limit order”

3. Be patient, may take a couple of days to fill

4. Monitor the process, adjust limit if necessary

Sell Immediately toAvoid Termination

Process

ETF Dangers & How to Conquer Them

1) Liquidity Dangers Focus on larger ETFs2) Execution Dangers Always use limit orders3) Structure Dangers

Know what you are buying

4) Closure Dangers Avoid liquidation process

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DisclosuresPast performance is not a guarantee of future results. All investments involve risk and there is always the possibility of incurring a loss as well as the potential for profits.

Ron Rowland, along with clients and employees of CCAM, utilize the strategies presented here and will typically hold positions in any securities recommended.

Performance data for Capital Cities Asset Management (CCAM) examples are based on the composite of all accounts under management that were in the referenced investment program for the entire quarter and includes reinvestment of all dividends and distributions. Reduction due to management fees has been accounted for. The performance of individual accounts will vary from the composites presented. Performance results for All Star Investor are not representative of those achieved by clients of CCAM due to differences in security selection, timing of trades, transaction fees, and CCAM’s management fees.

It should not be assumed that investments made in the future will be profitable or will equal the performance of the securities mentioned or that the mentioned investments were or will be profitable. The securities discussed do not reflect all recommendations in this investment category, but a complete list of recommendations for the past year will be provided upon request.