Exotic ETFs can blow up portfolios looks at the exchange traded fund universe in the White Top Investor lessons, Investment Choices. Managing Investment Markets Risks, Lesson 4. Exotic ETFs can blow up portfolios, discusses basic investment choices. This post covers the broad range of other ETF products beyond the basic ones covered in our last two discussions. Links to all parts of the White Top Investor course, Investment Choices are at the end of this post.

Basic ETFs make up most offerings of EFT financial products from a myriad of suppliers. Do your homework and you can use the basic ETF products with confidence. Exotic ETFs are entirely another story. Exotic single, double, triple and quad leveraged and inverse ETFs are extremely explosive and for expert use only.

Warning, Exotic ETFs can blow up portfolios!

Regard ETFs, other than the basic ones, as exotic, advanced and only for informed use in special situations. They should only be used by able and experienced investors with knowledge of the specific product that they intend to use. 

The Positives

Specialized exotic ETFs are financial products offering investors an easy way to play a great variety of more advanced market, trading and speculating strategies. Using them gives an investor the ability to have a leveraged, inverse or short, commodity linked, hedged, daily or monthly rebalanced approach. All advanced strategies that demand a high level of knowledge and experience to use well.

Exotic ETFs are not used in investing strategies. Rather traders and speculators use them in advanced strategies. When used well, by knowledgeable players, exotic ETFs can produce excellent and extreme profits. Without exception, all such use of exotic ETFs carries a very high risk exposure.

Levered ETFs Need Rebalancing

Rebalancing is a feature of exotic levered ETFs. Rebalancing means the managers of many exotic ETFs can add or subtract the number of shares available to the market each day. Rebalanced funds undergo a daily, or at times monthly, rebalancing or adjustment.

Rebalancing is typical among levered funds. Levered funds are funds with daily price movements 2, 3 or even 4 times the underlying market, stocks or commodity that they track. That produces greatly magnified price and volatility movement.

Wild price changes happen when using these products! Rebalancing seeks to modulate supply and demand that pushes the price to extremes due to either buying or selling pressure. In that sense, they are professionally manipulated to modulate market forces but to actually mirror the daily tracked price movement.

The rebalancing happens when supply (sellers) and demand (buyers) becomes unbalanced. That is "fund management speak" meaning the price movement, based solely on buyer and seller supply and demand pressure, is less or greater than the price change in the tracked item or market. Management adds or withdraws the amount of stock available for trading, to rebalance the price so that it reflects the tracked price.

As we know, in open unrestricted markets, prices quickly move in response to any imbalance. With unrestricted supply and demand, prices quickly have extreme moves. Those moves can outrun both the price and volatility of any tracked price. From that point of view rebalancing makes sense and is vitally important.

Without rebalancing, levered ETFs would very quickly show wildly exaggerated price moves beyond the price they are to track. That would quickly make them a meaningless product that would certainly fail as a financial product in the market. So rebalancing is good, and in fact essential, to make leveraged ETFs viable financial products.

Essential Rebalancing ETFs Can Unbalance Your Portfolio!

As often happens, good for them, not necessarily good for you! In fact, you can financially suffer from rebalancing! It can seem like an obscure risk and is certainly not self-evident. This risk exposure happens when you hold a leveraged ETF when you should not.

Holding exotic levered ETFs in volatile, choppy, up and down markets can quickly do very serious damage to a portfolio. This happens because rebalancing has the effect of clipping results on every price reversal. When the market has turn after turn each reversal can take a slice from your portfolio. In choppy markets loses compound. Portfolio weight reduction made easy!

Incredibly, you can actually be right on picking an overall market direction, but still lose much of your money! That happens when the market chops up or down day after day! When the trend is not smooth and steady each turn takes a slice of your money. In such markets do not touch levered ETFs.

There is much to learn about using levered ETFs well. Be certain you learn before you ever try to earn or your portfolio will burn! Very few financial advisors have a good understanding of these products so any beginner will certainly not. Be safe, every new investor should simply say no to all levered or exotic ETFs.

ETFs For Every Real or Imagined Need

It can seem as if there are countless other ETFs of endless variances and nuances for every market and every market condition. These exotic, specialized and very effective products demand great care and attention to use well. Particularly in the leveraged and inverse ETFs, where much financial danger lurks.

They are useful and very right for advanced trading strategies by knowledgeable and very experienced players. They are straightforward and dangerously easy to buy and sell. And very profitable when used in the right conditions.

But only use them IF you understand their structure and formulas as well as both the specific market and product being bought, shorted or played. That’s a lot of big important ifs and much to learn.

Timing Tool

Many of the exotic ETFs are useful when timing the market or catching swings. These timing tools work well when on the right side of the trade. However, that means you must know how to catch the market at the right time. That demands close attention and monitoring.

Timing is doable, but very risky and certainly not for the casual player. That means you need knowledge about the specific ETF you intend to use as your trading tool. Second, you need experience in entering and exiting trending trades with a profit. Finally, you must also catch the right side of a market swing so you must know how to correctly identify the market swings.

Those are three tall orders. Playing this game pits you against competition that includes the most skilled professional traders. Few experienced investors this product well. Few financial advisors actually know and understand the exotic ETFs. If you are a beginner you are certainly not ready to touch them!

They are an extreme play on market timing and movement. Correctly used, in proper conditions, they produce stunning and rapid profits. However, get it wrong and you soon experience the awful sucking sensation of a financial black hole!

EXOTIC ETFs Caution Aggressive Investing - Basic Homework Will Keep You Safe 

The best way to successfully manage exotic ETF risks - do your homework. You will avoid this entire area of risk with very little basic due diligence which always keeps you safe.

Google the name or ticker (the stock market symbol) of any ETF you might consider. The sites you find describe the fund and list the assets. Any description making reference to a leveraged or inverse strategy should get a pass. Look before you leap and you will be fine. That is how you manage the risk of exotic ETFs. Just avoid them.

Terminate any financial advisor that recommends or puts an exotic or levered ETF in the portfolio of any but the most advanced and knowledgeable client. Terminate them, sue for losses and report them to regulators. Make lots of noise.

I feel so strongly about this issue because I am aware of clients abused by bad financial advisors using these products. Millions have been lost. Too many unsophisticated but trusting investors have lost large sums of money because they inappropriately held exotic leveraged ETFs.

ETF Links and Resources

For anyone interested in learning more about ETFs, follow the link below.  Rob Carrick’s Portfolio Strategy column suggests many other ETF related links. It appeared the Saturday, July 27, 2013 issue of The Globe and Mail and gives excellent coverage of the ETF universe, “ETFs: Everything you ever wanted to know”. 

Next post in this series we begin to discuss my favorite, stocks! Stocks or equities are the 3rd of the big three market choices. This is where I love to rock & roll!

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Managing Investment Market Risks, lesson links:

Introduction to Managing Investing Market Risks Lesson 1

Dangerous dividend warning signs Lesson 2

Investor retirement saving dangers Lesson 3

Exotic ETFs blow-up portfolios Lesson 4

Stock scam awareness defense Lesson 5

4 Stock scam tips Lesson 6

Bitcoin fraud trust and psychology Lesson 7

Investors hold patient cash Lesson 8

3 Risk or opportunity signals Lesson 9

Option risks, dangers and opportunities Lesson 10

Cautious look at options Lesson 11

Selling low melts wealth Lesson 12

Next lesson 5: Stock scam awareness defense

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