This move is not directly related to last year’s decision by the Commodity Futures Trading Commission to enforce position limits on ETFs that use regulated futures contracts.  You may recall that turmoil in commodity-related ETFs followed the CFTC action.

The SEC move is unlikely to have such an immediate impact but could pose a long-term problem.  Sponsors who have built their business around leveraged, inverse, and commodity-based ETFs are particularly vulnerable since almost all such funds depend on various kinds of derivatives to execute their strategies.  This category includes Direxion, ProShares, Rydex, and several smaller firms.

The SEC seems to be concerned that investors in these funds do not understand the additional risks.  They are perfectly correct: plenty of investors obviously don’t know what they are getting into.  That’s why they get angry and file lawsuits after they lose money, despite the many warnings and disclosures they apparently ignore.

My best guess is that the SEC will, following its review, allow ETFs to continue using derivatives, though maybe with some new restrictions and additional disclosures.   Meanwhile, we probably won’t see any new leveraged, inverse, or commodity-based ETF launches.  Exchange-Traded Notes (ETNs) fall into a different category, so we may see sponsors switch to that format in some cases.

Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

I also have a long history of using Fidelity funds, especially their Select sector and industry funds.  These funds were originally targeted at active traders and even had hourly pricing.  In recent years Fidelity has taken many steps to deter short-term trading in their entire fund family.  Since many of my subscribers are still fans of Fidelity funds, I continue to track them too.  Here then is a compilation of the latest news from these fund families:

Direxion Funds

As of the close on September 30, 2009, all Direxion leveraged mutual funds changed their objective from daily to monthly tracking.  Leverage was also reduced from 2.5x to 2x for many of the funds.  Additional information on monthly leveraged mutual funds can be found on the Direxion website and in our previously published article.  Information on the Direxion Alternative Strategy funds can be found in our April Direxion Funds update.

Fidelity Funds

Fidelity Select Paper and Forest Products (former ticker = FSPFX) and Fidelity Networking and Infrastructure (former ticker = FNINX) stopped trading on June 19, 2009.  The Fidelity website no longer contains any information on either fund.  Both funds were closed to new accounts back in March.

As of August 31, 2009, Fidelity Small Cap Retirement Fund (FSCRX) was renamed Fidelity Small Cap Discovery.  The name change will not affect how the portfolio is managed.  The portfolio’s investment strategy and benchmark are not changing. Since inception, Fidelity Small Cap Retirement has been intended exclusively for institutional retirement plans.  The portfolio is being renamed to reflect that the fund will no longer be restricted to retirement accounts.

ProFunds

ProFunds posted an “open letter” on leveraged and inverse funds a while back.  I believe the class action suit against ProShares is without merit.  When visiting in the ProFunds website, one of the headlines definitely caught my eye: ProFunds Names Doberman General Counsel.

Rydex Funds

Effective August 1, 2009, Rydex Commodities Strategy (RYMBX) removed its short-term redemption fee (formerly 1% for shares held less than 30 days).

Rydex|SGI Long/Short Commodities Strategy Fund (RYLFX) began posting a daily NAV on June 25, 2009 although it wasn’t officially announced until two weeks later with the July 6 press release.  According to the overview, the fund seeks to match the daily performance of the JPMorgan Core Commodity-Investable Global Asset Rotator Sigma Long-Short Total Return Index.  The fund has a net expense ratio of 1.83% and a 1% redemption fee on shares held less than 30 days.

Back on May 27, Security Global Investors and Rydex Investments launched a unified brand strategy that “reflects the enhanced value that an integrated Security Global Investors and Rydex Investments bring to the marketplace, including a full range of investment management solutions spanning the asset allocation spectrum.”  As a result, many but not all Rydex funds are now called Rydex|SGI funds.

Information on many changes that Rydex implemented earlier in the year can be found in our April Rydex Funds update.

Disclosure (compliant with FTC 16 CFR Part 255):  I have no positions in any of the companies or ETF sponsors mentioned.  I have never received any income, revenue, or fees from, or on behalf of, any of the companies or ETF sponsors mentioned.

We’ve talked before about the perceived problems of daily reset for leveraged funds.  In fact, these funds have almost always performed exactly like they are supposed to perform.  The problem is that people do not understand them.  Sponsors like Direxion, ProShares, and Rydex have done their best to educate people, but some still don’t get it.  The result is lawsuits and a regulatory crackdown.

Direxion is obviously trying to address this concern by changing the way their leveraged mutual funds work.  This may be effective in terms of marketing strategy, but I’m not sure it will make regulators or lawyers any happier.  All Direxion is doing is exchanging one set of problems for another.

First, moving the leverage reset from daily to monthly will not stop the mathematical decay of these funds.  At best, the decay will slow down.  People will still see a mismatch when they look at long-term performance.

Second, one-month spans are far more likely to contain big moves than one-day spans.  This is important because a fund that is 2X or -2X leveraged will, in theory, be wiped out by a 50% move in the opposite direction.  A one-day move of 50% is unlikely in the indexes tracked by Direxion.  A 50% swing within a one-month period is also unlikely, but the potential is still much higher.

Third – and probably most important – anyone who buys one of these funds in the middle of a month will not know what leverage factor they are getting.  It could be 2X, 1.5X, 3X, or anywhere in between.  This will force long-term investors to bunch their transactions around month-end and probably mean less volume the rest of the month. 

Having said all this, I am glad to see Direxion innovating in their product design.  The truth is we will probably never get a “perfect” ETF that works for everyone.  Investors all have their own objectives.  Sponsors are all trying to find their niche.  Has Direxion hit on something that will work?  Only time will tell.

And yet, we like to remind our readers that better-than-expected employment figures are not the same as good ones.  Consumers make up 70% of economic activity.  When a significant portion of consumers are out of work, they’re not likely to buy more plane tickets, toy trains, or automobiles.  In short, the bleeding may have stopped, but our economy has lost a lot of blood.  That’s one reason stocks may trade more or less sideways for a long time. 

Now is not the time to get aggressive on the long side. Gateway Fund (GATEX) is an open-end mutual fund with less risk than a typical diversified growth fund, and it’s an idea to consider in a market that may trade sideways for a long time.  According to their fact sheet, GATEX is “a hedged-equity portfolio that seeks to capture the majority of returns associated with equity securities with less risk than other equity investments.”  In other words, if you like stocks but want to reduce your market volatility, GATEX may be for you.

The Gateway Fund has an excellent strategy for a choppy market.  The managers purchase large cap domestic stocks like Exxon (XOM), AT&T (T), Microsoft (MSFT), Johnson & Johnson (JNJ), and JP Morgan (JPM), then they sell call options on the stocks.  The revenue from the call options provides a cushion against market losses.  It also means the fund will not rise as much in a bullish market.

In essence, Gateway gives up some potential on the long side in exchange for better returns during a correction.  Although GATEX will decline in value when the market falls, it has done better over the long haul because of the option income.

The fund’s managers have proven the theory in both the short-term and long-term.  As of 6/30/09, the S&P 500 Index fell -26.2% over the previous 12 months.  At the same time, GATEX was off only -12.8%.  Even better: over the past 10 years, yearly returns averaged 2.66% versus the S&P losing -2.22% per year.  Not a bad record.

GATEX is best in a choppy, sideways market, but it is still a good long-term bet for risk-averse investors who want equity exposure.  Take a look at GATEX when we get the next market correction.  We suspect you’ll be glad you did.

In June, FINRA issued a warning to brokers and investment advisors regarding leveraged and inverse ETFs.   We predicted at the time that brokerage firms would likely place some restrictions, but we never envisioned a total ban.  We reported the release from FINRA contained something that ought to put a chill up the spine of leveraged ETF marketing executives: “…inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”  This is legal-speak for “Don’t sell these to anybody except day traders.”

By July it was apparent that the FINRA warning had a greater impact on the legal departments of the brokerage houses that sold these products than on the leveraged ETF marketing executives.  After all, the ETF sponsors have long warned of the dangers that can come from misusing these products and all provide warnings and educational material.  Here are links to such information for DirexionShares, ProShares, and RydexShares.

Edward Jones was the first to ban/cut leveraged ETFs from their lineup according to a July 21 article in the Wall Street Journal.  Next came reports that LPL Financial, Ameriprise Financial, and UBS were also banning the products.

I’m not sure what their real motives are, but the actions taken by these brokers seem insincere.  Here are some of the reasons why I feel this way:

1. Funds that use a “daily reset” of their leverage and inverse exposure are nothing new.  The first leveraged fund was Rydex Nova (RYNVX), launched in July 1993 (16 years ago).  Rydex Ursa (RYURX), the first inverse fund, came out six months later in January 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).
2. In late 1997, ProFunds introduced 2x long and 2x inverse funds that reset their target exposure on a daily basis.  This was nearly a dozen years ago.  Leveraged and leveraged inverse funds are nothing new.
3. The math has not changed.  The mathematics were the same in September 1994 when RYNVX and RYURX were both showing year to date losses.  The mathematics were the same in the early part of this decade when 2x long ProFunds Ultra Nasdaq 100 (UOPIX) and 2x inverse ProFunds UltraShort Nasdaq-100 (USPIX) both had double digit losses while the underlying index had a gain.
4. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer leveraged and inverse mutual funds.  When it comes to daily reset of leveraged and inverse exposure, there is no difference between ETFs and mutual funds.
5. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer put and call options to their clients.  It is a well known fact that many options expire worthless and investors lose 100% of their investment (plus commissions).  To my knowledge, no leveraged or inverse ETF has ever lost 100% of its value.  Options are more risky than leveraged ETFs.
6. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer short selling to their clients.  It is a well known fact that short-selling is risky and the potential loss can be well in excess of your entire investment.  With inverse ETFs, your risk is limited because no ETF has ever lost 100% of its value.  Short selling is more risky than leveraged ETFs.
7. Many, if not most, of the brokers that have banned leveraged and inverse ETFs still offer margin accounts to their clients.  It is a well known fact that margin accounts are risky and the potential loss can be in excess of your entire investment.  The value of your leveraged and inverse ETFs should never decline by more than your investment.  Margin accounts are more risky than leveraged ETFs.

The fact is that the “daily reset” of leverage actually protects investors from blowing themselves up.  It prevents a position from going to zero, it prevents margin calls, and it prevents the unlimited loss potential of short-selling.

These products should not be banned.  They should be hailed as great achievements in risk management.  They are actually protecting investors from themselves.

Disclosure:  I currently own a few leveraged and inverse products.  I have been using them since 1994, and they have always performed as stated in the prospectus.

It may be too soon to celebrate.  The S&P 500 has yet to convincingly break above the intermediate trading range.  If you bet the farm on stocks, you may need to mortgage it in the near future.  With Obamacare in the works in Washington and mixed signals throughout the economy, we think it’s too soon to go long in force.

That’s why we’re opting for a more conservative pick this week.  Reviewing less-aggressive options, we typically like lower risk ETFs.  But every once in awhile an open-end mutual fund makes sense.  We searched far and wide for a best of breed balanced fund.  In this case, T. Rowe Price Capital Appreciation (PRWCX) fits the bill.  Its unique allocation and low expense ratio make this a compelling fund for almost any environment.  Here are a few reasons we like PRWCX:

First, it’s lighter on stocks than equity-only funds, and the primary reason it falls under the balanced category.  At the end of June, the fund only held 61.1% in stocks.  Although that’s not the best situation for a skyrocketing market, it makes for a steadier ride during uncertain times.  Stocks can sway your results dramatically, but PRWCX would tend to hold up better if the market falls.

Second, PRWCX yields 2.37%.  A steady payout is nice to have in shaky markets.  Dividends come from both corporate earnings and bonds.  Domestic bonds comprise 10% of PRWCX holdings.  The fund also has a sizable position in convertibles – bonds with the option to turn into stock.  This 12.7% convertible allocation tends to protect the portfolio in a down market but could give it an extra boost in an up market.

Third, PRWCX can move aggressively amongst asset classes, and has the leeway to hold large portions of cash.  This is a substantial benefit in bear markets.  For instance, as of June 30 PRWCX was holding almost 15% of the portfolio in cash.  That protects the downside while also providing buying power when stocks or bonds get unusually cheap.  The fund has a value bent, and seeks to buy stocks that are out of favor.  A large pile of cash helps accomplish this goal when opportunity knocks.   

The chart looks positive for PRWCX.  Unlike the S&P 500, PRWCX recently broke above its June trading range.  An uptrend is definitely in place.  Although we expect it to continue rising, there could be a correction if the market doesn’t break out of its current trading range.  Frankly, this fund shouldn’t be thought of as a trading vehicle anyway.  It is best used as a core holding for investors seeking long-term capital appreciation. 

A few caveats related to this mutual fund.  To invest in PRWCX, you’ll need at least $2,500.  In addition, management expenses will eat a small portion of your return (currently at 0.72%) – but it’s still reasonable.  In addition, like all mutual funds, you can only trade with end-of-day pricing.  To go with a conservative fund in an uncertain market, buy PRWCX.

130/30 funds have been one of the biggest product disappointments in the mutual fund world.  On paper, these funds sound great – use 30% of the fund’s assets to sell short stocks with the least favorable outlook, and then boost the allocation of your best long ideas by 30%.  The net result being a portfolio having 100% market exposure combined with a long/short twist to help provide positive alpha.

In practice, the results have been far from impressive.  According to a quick screen of Morningstar data, there were 14 equity based 130/30 funds (additional share classes excluded) in operation throughout calendar year 2008.  On average, they returned -39.8% versus -37.0% for the S&P 500.  The best performer was CRM 130/30 Value (CRITX) (overview) with a return of -33.9%.  The worst was RidgeWorth International Equity 130/30 (SCEIX) (overview) with a -54.4% return.

In May of last year, the first exchange traded product to use a 130/30 strategy hit the market with the launch of First Trust Enhanced 130/30 Large Cap Index (JFT) (ETN summary).  At that time, Roger Nusbaum provided his thoughts on JFT for an article by Murray Coleman of IndexUniverse.   JFT has also been a disappointment, suffering a loss of -54.2% from inception (as of 7/13/09) versus -33.4% for the S&P 500.  Additionally, JFT has failed to attract assets and trading activity, placing it at #7 on the latest ETF Deathwatch list.

For ProShares, CSM represents the first of a new ETF category: Alpha ProShares, which are designed to provide advanced investment strategies in the form of ETFs.  The introduction of ETFs based on quant strategies has been a growing trend.  The fund’s operating expenses will be capped at 0.95%.

According to the press release, the underlying index was introduced in 2007 by Credit Suisse in collaboration with AlphaSimplex Group.  It was designed by Dr. Andrew Lo, in collaboration with Mr. Pankaj Patel, CFA.  Dr. Lo is Chairman and Chief Scientific Officer of AlphaSimplex Group and Harris & Harris Group Professor at the MIT Sloan School of Management.  Mr. Patel is Director of Quantitative Research at Credit Suisse.

Dr. Lo and Mr. Patel described the underlying principles of this quantitative-based index in their award-winning 2008 paper, “130/30: The New Long-Only,” in The Journal of Portfolio Management.

So, the question of the day is: will the brain-trust and fire power behind CSM make it any better than its peers?  The answer is: only time will tell.

Disclosure: no positions

The Investor Guide says community banks now make up 96% of all banks in the US and play an important role in our nation’s economic system.  The guide goes on to say, “There has been little distinction made between the stress-tested megabanks and the nearly 8,000 community banks throughout the country.  Community banks tend to be more cautious than their larger counterparts and take less risk when making lending decisions.”

The index is market-cap weighted and includes Nasdaq-listed banks and thrifts.  However, the underlying index and QABA will not let just any community bank be included.  To help ensure the intent and purpose of this ETF, it will exclude:

• The 50 largest banks or thrifts and their holding companies
• Banks or thrifts classified as having an “international specialization”
• Banks with a “credit-card specialization”
• Securities with a market capitalization under $200 million
• Securities with less than $500 thousand average daily value traded (ADVT)

The fund expects to have about 100 holdings and an expense ratio of 0.60%.  Additional information is available at the First Trust website.  Gary Gordon, of ETF Expert, believes that QABA may be a huge hit, and I agree.  First Trust has earned first-mover status for ETFs in the community banking industry.

I find this interesting because I’ve seen this sector take off like a rocket before.  In more than twenty years of trading Fidelity Select funds, one of the few managers I remember is David Ellison of Fidelity Select Home Finance (FSVLX).  The fund was called Fidelity Select Savings & Loan at the time.  As any long term mutual fund tracker knows, David put that fund at the top of all the performance charts in the 1990s, delivering returns of more than +40% per year for an extended period.  And he did it by investing in community banks, much like QABA is going to do.

By the way, David Ellison is currently the President of FBR Fund Advisors, where one of his duties is managing a similar fund, the FBR Small Cap Financial (FBRSX).

Disclosure:  no positions

First, let’s take a look at TUZ.  At first glance the new fund appears very similar to the iShares 1-3 Year Treasury Fund (SHY).  PIMCO is waiving fees to bring the expense ratio down to 0.09%, below the 0.15% found in SHY.  Look for iShares to respond with lower fees soon.  Both TUZ and SHY are aimed at income investors who want the potential for a higher yield than is available in short-term Treasury bills which mature in a year or less, while also keeping interest rate risk relatively low.  See the Fact Sheet and Prospectus for more info on TUZ.

Industry watchers have long wondered why some of the large mutual fund sponsors have failed to respond to the competitive threat posed by ETFs.  We even thought a few months ago that Fidelity might make an offer for iShares.  Apparently not, though the bidding is still open.

For PIMCO to make its very first ETF launch a near-clone of an existing ETF, and then to compete on expenses, is a very bold move.  PIMCO also has the trading and marketing muscle to keep its funds active and liquid.  The other large fund sponsors cannot ignore this development.  At the same time, they will have a hard escaping the high-fee, performance-based culture that served them well for decades.

TUZ is only the beginning; PIMCO has other ETFs on the drawing board including its recent filing for six more – three TIPS and three additional Treasury ETFs.  Whatever happens, it seems clear the ETF industry is due for some big changes.

Disclosure:  long SHY

Once upon a time, there was a company that was a true pioneer in the mutual fund business.  Their global approach to growth investing (from bygone decades) with the likes of the Magellan Fund (FMAGX) is truly legendary.  In the early 1980s they introduced a series of sector and industry funds known as the Fidelity Select Portfolios.  These products were geared for active traders, with hourly trading and virtually no transaction or redemption fees.  At one point, Fidelity even had “stock baskets” comprised of the top holdings of the more popular Select funds, and those baskets could be shorted.

Somewhere along the way, the mutual fund arm of Fidelity seems to have lost its pioneer spirit.  They added redemption fees to the Select funds as well as most of their international and small cap funds.  Hourly pricing is now just a footnote in history, and 30-day roundtrip rules apply to their entire fund lineup (except money market funds).

Many of these restrictions were put in place just as the ETF business was starting to gain traction.  Some Fidelity watchers, myself included, thought the company was getting ready to enter the ETF business in a big way, with the mutual funds restrictions intended as a way to separate the mutual fund investors from the ETF traders.

No such thing happened, and today Fidelity is noticeably absent from the ETF space.  Yes, they do have one product, the Fidelity Nasdaq Composite Tracking Stock (ONEQ), which seems to only draw attention to the fact that the ETF world has passed them by.  Fidelity recently had a chance to get back in the game in a big way when Barclays decided to sell their iShares unit.  However, it appears they let this chance get away also.

Still, Fidelity is a major force in the mutual fund world.  The company has many fans.  Even though I prefer ETFs over mutual funds, I still have two strategies in my All Star Fund Trader newsletter that limit their selections to Fidelity funds.

Here then, is the latest news regarding Fidelity funds:

The Fidelity Global Commodity Stock Fund (FFGCX) was introduced on March 31, 2009.  The announcement states that the fund is not intended as a direct investment in commodities.  Instead it will invest in the “common stocks” of companies engaged across the commodities spectrum, maintaining a dedicated allocation to each of the metals, agricultural and energy industries. The fund will specifically invest in commodity-producing companies, which are typically more influenced by the performance of raw commodities, rather than companies that operate further up the supply chain (such as mining or energy equipment makers, refiners, distributors, etc).  FFGCX has an expense ratio of 1.75% and there is a 1% redemption fee on shares held less than 30 days.

Fidelity reopened the Fidelity Diversified International Fund (FDIVX) and the Fidelity Small Cap Stock Fund (FSLCX) to new investors and accounts on March 30, 2009.  Fidelity Diversified International Fund, which has been closed since October 2004, seeks capital growth by investing primarily in the common stocks of non-U.S. companies. The fund has been managed by William Bower since 2001.  Fidelity Small Cap Stock Fund, which has been closed since June 2006, seeks long-term growth by normally investing at least 80 percent of its assets in companies with small market capitalization.  Andrew Sassine has managed the fund since July 2008.