Friday, December 17, 2010

Dion, The Ultimate Guide to Trading ETFs

The Ultimate Guide to Trading ETFs: How to Profit from the Hottest Sectors in the Hottest Markets All the Time by Don Dion and Carolyn Dion (Wiley, 2011) is a workmanlike account of the benefits and pitfalls of investing in ETFs, many of which have been amply documented in the financial press and on blogs. The authors, however, give structure to the tidbits that the investor can pick up from other sources. The result is (contrary to the subtitle) a well-organized, balanced book that should serve the ETF investor well.

Although most investors know the advantages of ETFs over mutual funds, they are undoubtedly less aware of some of their potential disadvantages. The authors begin with the basics: appropriateness, liquidity, and concentration. Consider liquidity, for instance. The authors explain that ETFs have both primary and secondary liquidity. Primary liquidity refers to the liquidity of the fund’s underlying basket of securities whereas secondary liquidity refers to demand for the ETF itself. If either primary or secondary liquidity is lacking or dries up, the ETF “will tend to trade at a noticeable premium or discount” to its NAV. (p. 9)

Domestic, international, and derivative-based ETFs each come with their own sets of complications. International ETFs can become disconnected from their underlying equities because of time-zone differences; futures-based funds can trade at significant premiums to their NAV when position limits are imposed or threatened.

I appreciate a book that exposes the underbellies of trading vehicles since too many investors have a decent investing idea (hedge a winter’s supply of heating oil with an ETF, circumvent the short-selling restriction in an IRA by buying short ETFs, increase leverage with the 2X and 3X ETFs, gain exposure to an individual country with an ETF) without truly understanding the product they are using to execute their idea. How closely does it track the underlying? Is it best used for short-term trading or investing?

The authors stress again and again that the investor has to educate himself. For example, “there is a world of difference between … iPath Dow Jones-UBS Platinum Subindex Total Return ETN (PGM), which is based on platinum futures contracts, and ETFS Physical Platinum Shares (PPLT), which is backed by a physical stockpile of platinum. The word ‘platinum’ is the only thing these two funds have in common. The ways they provide exposure to that market are diametrically opposed.” (p. 152)

The book also has useful appendixes. One ranks all U.S.-listed ETFs and ETNs (as of April 30, 2010) on a scale of 1 to 5, a scale which is intended to be a guide to their complexity. A second is a tax guide for ETF investors. Yet another appendix offers sample portfolios for various trader/investor types.

The Ultimate Guide to Trading ETFs is not a revolutionary book. But any ETF investor who is not familiar with all of the material included in it is bound to stumble.

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