You already know that “exchange traded funds” trade on an exchange.  That’s what distinguishes them from old-fashioned mutual funds.  But what exchange trades them, and where is it?

For some new iShares, the answer isn’t New York or Chicago.  Their trading hub is Lenexa, Kansas.  Let me explain …

Exchange Floors No Longer Needed

For most people, the term “stock exchange” brings to mind images of noisy rooms filled with men in colorful jackets, waving their arms and making cryptic hand motions.

At one time, this is exactly how trading got done — and the apparent chaos was actually very efficient.  But now, even the nimblest floor traders can’t compete with the speed and accuracy of modern computers.

An “exchange” isn’t a physical place anymore.  It’s a mechanism by which buyers and sellers find each other.  Nowadays, it happens in milliseconds.

Not surprisingly, then, there’s no longer a need for traders and exchanges to stay in lower Manhattan.  The New York Stock Exchange and Nasdaq don’t get it — yet.  They will.  Their customers are going BATS.

Kansas: The New ETF Capital

From its headquarters in a Kansas City suburb, BATS Global Markets is now the nation’s third-largest securities exchange.  The company launched its first trading system in 2006.  Then in 2008, it was acknowledged by the SEC as a “national securities exchange” on par with the NYSE and Nasdaq.  BATS is an acronym for “Better Alternative Trading System.”

The founders of  recognized that stock exchanges are really in the technology business.  Trade processing isn’t rocket science, and it doesn’t take financial genius.  The keys to success are accuracy, reliability, and low costs.

Locating in Kansas is a great way to keep your expenses down.  Everything from office space to taxes is much lower than New York.  Over time (and millions of transactions) the difference adds up.

BATS — maybe because it has some distance from the traditional exchange culture — is innovating in other ways, too.  The company is planning a “Competitive Liquidity Provider” program that will give market makers a financial incentive to increase liquidity and keep bid/ask spreads tighter.

It’s working: Last year BATS had an 11 percent share of U.S. stock market activity.  The firm’s European unit, when combined with another exchange BATS is in the process of acquiring, had a 25 percent market share.

Now BATS is going for the jugular.  The upstart wants to lure primary listings away from the big exchanges, starting with ETFs.  iShares was the first sponsor to make the leap — but I bet more will follow.

Why You Should Care!

For small investors, this may seem like “inside baseball.”  You may not know or care how it all works. You just want to buy and sell at a fair price.  You trust your broker to handle the details.

That’s exactly why you should be glad BATS is on the scene.  The competition they’re creating, both for listing fees and trading volume, is what keeps your costs down.

So whether you knew it at the time or not, the January 24 launch of iShares MSCI Norway Capped Investable Market Index Fund (ENOR) on BATS was a big deal!  ENOR was the first of seven new single-country ETFs from iShares in January.  BATS is the primary exchange for all of them.  Two more are coming soon.

I don’t know if iShares intends to keep listing new ETFs on BATS.  Nevertheless, the vote of confidence from the world’s largest ETF sponsor means something.

Unfortunately, some stock quote services are not yet set up to recognize BATS as the primary (or only) exchange for securities.  I expect this to be fixed soon.  But in the meantime, you may have a little trouble getting quotes on the BATS-listed ETFs.

Will BATS take over the world?  No — there will always be room for competition.  But the fact that this firm exists at all is still remarkable.

ETFs were a revolution in themselves.  They’ve transformed the entire money management industry.  Now the revolution is entering a new stage — and you’re set to be one of the winners.

Disclosure covering writer, editor, and publisher:  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.  This article originally appeared in Money and Markets, a free daily investment newsletter from Weiss Research.  To view archives or subscribe, visit http://www.moneyandmarkets.com/.

Today we’ll look at some interesting patterns in last year’s sector action — which was quite different from the broad market.  Then I will make an observation about the way 2012 is starting off.

Little Sectors Win the Year

Standard & Poor’s classifies every individual stock into one of ten primary sectors.  They then publish specific indexes for each sector (as well as dozens of sub-sectors within the ten primaries).

So let’s see how each sector performed.  Some were above-average while others lagged.

Hmmm, what’s going on here?  Only three sectors had a losing year, and one of those was off less than 3 percent.  Meanwhile three other sectors had double-digit gains.  So how did the index end up at break-even?

The answer lies in the fact the S&P 500 is capitalization weighted.  This simply means that each stock — and therefore each sector — influences the overall index in proportion to its size.

As of 12/30/2011, the stocks in the S&P 500 had an adjusted market cap totaling almost $11.4 trillion.  Now, as we did above, let’s break it down by sector.

Now the index returns make more sense.  One of the three largest sectors (Financials) dropped 18.4 percent for the year.  The other two biggies (Technology and Energy) had gains in the low single digits.

Conversely, the best-performing sectors tended to be smaller …

Utilities had a great year, but that group represents only 3.9 percent of the S&P 500′s value.  The year’s other two big winners, Consumer Staples and Health Care, are middle sized.  This pair kept Financials from dragging the whole index down.

A Good Time to Stay Defensive

Another thing to notice about last year: The winning sectors were those traditionally thought of as “defensive.”  Utilities, Consumer Staples, and Health Care are often among the best havens in a weak economy.  That was certainly the case in 2011.

Will 2012 be the same?  Of course I don’t know what will happen, but I see some clues.

Utilities had a big rally in the last two weeks of the year.  SPDR S&P Utilities (XLU) gained about 5 percent in that short period … then lost half of those gains in the first week of January.

To me, this looks a lot like year-end “window dressing.”  That’s when portfolio managers pile into the yearly or quarterly winners so their clients will think they’ve been in the best stocks all along.  Once the calendar turned, buying interest dried up and the Utilities sector fell.

Health Care, on the other hand, has shown much steadier recent results.  SPDR S&P Health Care (XLV) actually outperformed XLU in the last quarter of 2011, rising 10 percent vs 8.2 percent for the Utilities ETF.

Bottom line: Not all “defensive” sectors are always equal.  I suspect Health Care will continue to outperform.  If you agree and would like to bet on this trend, here are the five largest diversified health care ETFs to consider:

• SPDR Health Care Select Sector (XLV)
• Vanguard Health Care (VHT)
• iShares Dow Jones U.S. Healthcare (IYH)
• iShares S&P Global Healthcare (IXJ)
• First Trust Health Care AlphaDEX (FXH)

Disclosure covering writer, editor, and publisher:  Long XLV.  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.  This article originally appeared in Money and Markets, a free daily investment newsletter from Weiss Research.  To view archives or subscribe, visit http://www.moneyandmarkets.com/.

What’s Wrong with Japan?

I’ve been to Japan many times.  I love the country and the people.  Yet I have to tell you that now is not the time to invest in Japanese stock ETFs.  Yes, I know the Nikkei Dow looks oversold, but it’s looked that way for years.  As I’ve explained before, calling a bottom is tough.  And I don’t think Japan is there yet.  Here are six reasons why:

#1 — Strong Yen

The yen was very strong in 2011 … which is bad news because it makes Japan’s exports relatively more expensive.  And exports are a BIG part of the national economy for Japan.

The authorities are well aware of this, of course, but there isn’t much they can do about it.  The Bank of Japan intervened multiple times last year.  In every case, the impact of their actions was gone within a few days.

#2 — European Recession

A huge chunk of Japanese exports go to Europe.  As you’ve surely noticed, the euro zone is having a few problems.  A severe recession — or at best a few years of low growth — seem likely for 2012 and beyond.

If Europeans have no money to spend, their demand for imports (from Japan and elsewhere) is going to plummet.  This is another bad sign for Japan.

#3 — Hungry Competitors

Japan reached economic success by beating the developed countries in cheap, efficient manufacturing.  Now they have competitors: Taiwan, South Korea, Brazil, India … and of course China.

The challenge for Japan is that all these other countries can do the very same things that put Japan on the map.  And in some cases, they can do it better.  Nations like Brazil have other advantages, too, like better access to natural resources and geographical proximity to key markets.

#4 — Aging Population

Japan is, on average, one of the oldest nations on the planet.  Furthermore, the relatively small number of young adults has a very low birth rate.

The resulting imbalance is making it harder and harder for Japanese industry to keep growing.  Older workers hang on to their jobs for dear life while younger people have no way to gain skills.  We’re seeing a similar pattern here in the U.S., but in Japan it’s a much bigger problem.

#5 — Massive Government Debt

Japan’s national debt is projected to surpass 1 quadrillion yen in 2012.  A big cause is the population imbalance noted above.  All those older people require heavy spending on health care and pensions.

To stay afloat, Japan will almost certainly need to raise taxes on both individuals and businesses.  And higher taxes won’t make it any easier to create economic growth.  

#6 — Political Instability

Japan’s parliamentary government used to work pretty well.  Now it’s turning almost as dysfunctional as Italy and Greece.

Consider this: Japan has had six different prime ministers since 2006.  The current occupant, Yoshihiko Noda, took office in September 2011 and is already under fire.

The real problem isn’t the government; it’s the voters and their unrealistic expectations.  Changing leadership is just a symptom.

Japan-Heavy ETFs to Avoid

Japan may well have short-term rallies in 2012, but I still think the best opportunities will be elsewhere.  Here are some ETFs with heavy Japan exposure:

• WisdomTree Japan Small Cap Dividend (DFJ)
• WisdomTree Japan Hedged Equity (DXJ)
• iShares MSCI Japan (EWJ)
• iShares S&P/Topix Japan 150 (ITF)
• SPDR Russell/Nomura Japan (JPP)
• SPDR Russell MidCap Japan (JSC)
• iShares MSCI Japan Small Cap (SCJ)
• db-X MSCI Japan Currency-Hedged Equity (DBJP)
• MAXIS Nikkei 225 Index Fund (NKY)
• Vanguard MSCI Pacific ETF (VPL) (62% allocation to Japan)

If any of these are in your portfolio, I suggest you look for a chance to get out as soon as possible.

There is an ETF that is designed to go up as Japanese stocks fall.  ProShares UltraShort MSCI Japan (EWV) is a 2x leveraged inverse fund.  However, I don’t recommend EWV as a long-term investment.  It is a short-term trading instrument.  (See Three Overlooked Risks of Inverse ETFs to learn more.)

So what do you do with the cash you aren’t investing in Japan?

Good news: You have plenty of opportunities elsewhere.  I’ll be telling you about some of them in my Money and Markets columns as the year unfolds.  And if you’d like more specific recommendations on what to buy and sell, click here and check out my International ETF Trader service.

Disclosure covering writer, editor, and publisher:  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.  This article originally appeared in Money and Markets, a free daily investment newsletter from Weiss Research.  To view archives or subscribe, visit http://www.moneyandmarkets.com/.

When it comes to defining the best solution for this task, there are two major camps – and they rarely see eye-to-eye.  In one corner are the total return proponents.  They believe the optimum approach is to manage the portfolio for total return.  They assume the income generated by the portfolio will not be sufficient to cover retirees’ annual financial needs and therefore some holdings will need to be sold to make up the shortfall. 

In the other corner is the dividend income camp.  That camp believes the optimum approach is to invest strictly in dividend generating securities that kick out the required income without ever having to sell any holdings.  The dividend camp makes some compelling arguments, but that is a subject for another article.

Today, I want to focus on what I see as the single largest flaw of the dividend crowd:  They do not acknowledge the fact that dividends can and do experience declines.  This failure results in not having a thoughtful plan for those occurrences.

Let’s take some real-life examples.  We need some basic assumptions, so we’ll start with the widely accepted 4% rule for first year withdrawal.  If you are not familiar with the rule, it puts forth that to minimize the chance of outliving your nest egg the most you can withdraw from your portfolio balance the first year is 4% and that amount can be adjusted upward each year for inflation.  There are numerous variables and it won’t work for every situation, but it is a good starting point.  If you start with $1 million and assume a 3% inflation rate, then the 4% rule says you can withdraw $40,000 the first year, $41,200 the second year, and so on.  The withdrawal amount is independent of your portfolio balance in subsequent years.

The total return investor probably holds a mixture of stocks and bonds, and the portfolio may only throw off about 2% in dividends.  The total return investor is counting on portfolio growth to stay ahead of inflation and to cover the shortfall in annual income needed versus dividends received.

The dividend investor requires a 4% initial portfolio yield.  This approach requires sufficient dividend growth to allow future distributions to keep pace with inflation.  The major flaw with this approach is that there is nothing sacred about dividends and they can be decreased, thereby creating the necessity for the devout dividend investor to convert to a total return investor at an inconvenient time. 

I have prepared the following table as a case study.  It clearly illustrates that dividend investment strategies can and do experience severe declines in dividend payouts.  The largest dividend ETF, iShares Dow Jones Select Dividend ETF (DVY), had a 31.4% reduction in dividends from 2008 to 2009.  The 2010 per share distribution amount was 29.8% below the 2008 level.

Income From Largest Dividend ETFs 2008-2010

Table sorted by assets under management. Annual ETF dividend income data from Morningstar.  Current yield data from Ned Davis Research.  Data compilation by InvestWithAnEdge.com.

Let’s assume a person embarked on a dividend-based withdrawal plan in 2007 or 2008 and bought enough shares of DVY to supply $20,000 in annual dividends in 2008.  That person planned on dividends rising by 3% to $20,600 in 2009 to offset inflation.  Instead, they received only $13,719 from DVY.  They couldn’t make up the difference with other dividend ETFs because, as the table clearly shows, most of the others were just as bad, if not worse.

Our dividend investor is left with no choice but to sell some holdings to make up for the income shortfall.  To add insult to injury, the dividend streams still have not returned to their prior levels, forcing the dividend investor to sell again in 2010 and 2011.  Even if dividends remarkably return to 2008 levels in 2012, our dividend investor has sold off a portion of the portfolio plus experienced four years of inflation, and therefore portfolio level dividends will still be insufficient.

One argument I expect to receive is that these ETFs are not good examples because they don’t own the best list of dividend stocks.  My counter argument would be that the underlying indexes are created by knowledgeable experts.  Any list that you generate today, consisting only of companies that have never cut their dividends, is a list that suffers from extreme survivor bias.

Another argument might be to put it all in the Vanguard Dividend Appreciation ETF (VIG) since it had a smaller decline and has already fully recovered.  However, VIG and similar strategies only generate about a 2% yield – far short of the 4% needed.

If you are going to point out that the yields on these ETFs actually increased in 2009 (their prices fell more than their dividends), my counter argument will be that it doesn’t matter to our 2008 retiree.  Current yield only matters to new money being invested.  By definition, our investor is in withdrawal mode and not accumulation mode.  He has no money to invest at these new lower prices and higher yields.

Disclosure covering writer, editor, and publisher:  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.

Deutsche Bank made its debut as a solo ETF provider earlier this month, and effective 6/17/11 it rebranded the xShares/TD Ameritrade target date funds acquired in June 2010.  The funds will also get new CUSIPs, but the ticker symbols will not change (revised prospectus):

• TDX Independence 2010 ETF becomes db-X 2010 Target Date Fund (TDD)
• TDX Independence 2020 ETF becomes db-X 2020 Target Date Fund (TDH)
• TDX Independence 2030 ETF becomes db-X 2030 Target Date Fund (TDN)
• TDX Independence 2040 ETF becomes db-X 2040 Target Date Fund (TDV)
• TDX Independence In-Target ETF becomes db-X In-Target Date Fund (TDX)

The Deutsche Bank website strategy for its U.S. ETPs is currently a mess with products scattered across three websites and no cross-links between them:

• http://www.dbxstrategicadvisors.db.com/ for these target date ETFs
• http://www.dbxetf.com/ for the currency-hedged ETFs
• http://www.dbfunds.db.com/ for the PowerShares branded ETFs and ETNs

WisdomTree’s previously announced changes to seven of its equity ETFs became effective yesterday (6/20/11).  Six ETFs now have new names and underlying indexes, and four of them got new ticker symbols.  One fund received a name change only.  The changes are summarized below:

• WisdomTree International Real Estate Fund (DRW) becomes WisdomTree Global ex-U.S. Real Estate Fund (DRW) and has broader global real estate exposure with the addition of emerging markets.
• WisdomTree International Utilities Sector Fund (DBU) becomes WisdomTree Global ex-U.S. Utility Fund (DBU) and has broader global utilities exposure with the addition of emerging markets.
• WisdomTree International Basic Materials Sector Fund (DBN) becomes WisdomTree Commodity Country Equity Fund (CCXE) and is a more diversified commodity-focused equity strategy that also adds emerging markets.
• WisdomTree International Energy Sector Fund (DKA) becomes WisdomTree Global Natural Resources Fund (GNAT) and is a more diversified energy/natural resources-focused equity strategy that also adds emerging markets.
• WisdomTree Pacific ex-Japan Total Dividend Fund (DND) becomes WisdomTree Asia Pacific ex-Japan Fund (AXJL) with an expanded portfolio becoming a broader Asia-Pacific regional strategy while adding emerging markets.
• WisdomTree Pacific ex-Japan Equity Income Fund (DNH) becomes WisdomTree Australia Dividend Fund (AUSE) and changes from a majority Australia weighted portfolio to a pure Australia dividend strategy.
• WisdomTree World ex-U.S. Growth Fund (DNL) becomes WisdomTree Global ex-U.S. Growth Fund (DNL) which is a name change only.

VelocityShares, a relative newcomer to the ETP space, announced share splits for its two inverse volatility ETNs whose share prices have gained significantly since launch:

• VelocityShares Daily Inverse VIX Short Term ETN (XIV) will undergo a 10-for-1 split effective 6/27/11, which should reduce its trading price from around $160 to about $16.
• VelocityShares Daily Inverse VIX Medium Term ETN (ZIV) will undergo an 8-for-1 split effective 6/27/11, which should reduce its trading price from around $130 to about $16.

Disclosure covering writer, editor, and publisher:  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.

The Direxion ticker symbol changes for 6/15/11 are:

• Direxion Daily China Bull 3x Shares changed its ticker from CZM to YINN (YINN overview)
• Direxion Daily China Bear 3x Shares changed its ticker from CZI to YANG (YANG overview)

The changes to the PowerShares ETFs will also include a reduction of their expense ratios from 0.61% to 0.39%.  The seven ETFs being revised effective 6/16/11 are:

• PowerShares Dynamic Large Cap Portfolio (PJF) becomes PowerShares Fundamental Pure Large Core Portfolio (PXLC)
• PowerShares Dynamic Mid Cap Portfolio (PJG) becomes PowerShares Fundamental Pure Mid Core Portfolio (PXMC)
• PowerShares Dynamic Small Cap Portfolio (PJM) becomes PowerShares Fundamental Pure Small Core Portfolio (PXSC)
• PowerShares Dynamic Mid Cap Growth Portfolio (PWJ) becomes PowerShares Fundamental Pure Mid Growth Portfolio (PXMG)
• PowerShares Dynamic Mid Cap Value Portfolio (PWP) becomes PowerShares Fundamental Pure Mid Value Portfolio (PXMV)
• PowerShares Dynamic Small Cap Growth Portfolio (PWT) becomes PowerShares Fundamental Pure Small Growth Portfolio (PXSG)
• PowerShares Dynamic Small Cap Value Portfolio (PWY) becomes PowerShares Fundamental Pure Small Value Portfolio (PXSV)

Missing from the list above is PowerShares Dynamic Large Cap Growth Portfolio (PWB) with a 0.61% expense ratio and PowerShares Dynamic Large Cap Value Portfolio (PWV) with a 0.63% expense ratio. 

For reasons unknown, PowerShares decided to let these two ETFs stand “as is” while launching two new ETFs that will directly compete with them and round out the RAFI style box offerings.  PowerShares Fundamental Pure Large Growth Portfolio (PXLG) and PowerShares Fundamental Pure Large Value Portfolio (PXLV) are two new ETFs that were listed for trading on June 16.

Here is the link to the overview page for the entire PowerShares lineup.  Additional information about the changes can be found in the prospectus supplement (pdf) and the PowerShares press release from January 2011 on RAFI indexes (pdf).

Disclosure covering writer, editor, and publisher:  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.

Claymore U.S. Capital Markets Bond ETF (USB), was launched more than three years ago, only attracted $5.3 million in assets, traded rarely, and became a regular member of ETF Deathwatch.  Rather than admit failure by closing USB, Guggenheim has given it a new name, new ticker symbol, and new objective.  The CUSIP and the 3-year track record did not change.  This ETF has been repackaged as Guggenheim Enhanced Core Bond ETF (GIY).

Claymore U.S. Capital Markets Micro-Term Fixed Income ETF (ULQ) had a similar story, except that it attracted nearly $20 million in assets.  On 6/1/11, ULQ morphed into Guggenheim Ultra-Short Bond ETF (GSY).

I’ll say it again so we are all perfectly clear: GIY and GSY are not new ETFs.  They are Extreme Makeovers of previously-launched products.  ETF sponsor Claymore pioneered this process in July 2009 when Claymore/Great Companies Large-Cap Growth Index ETF (XGC) mysteriously became the Claymore/BNY Mellon International Small Cap LDRs ETF (XGC).   I highly suggest clicking the link for some background.

Here the plot thickens.  Around the same time XGC changed its stripes, Claymore was acquired by Guggenheim but continued operating under the Claymore name.  I do not know for a fact that the sponsor’s ownership change had anything to do with the Extreme Makeover of XGC, but the timing was certainly convenient.

In any case, in August 2010 Claymore/Guggenheim did it again, transforming Claymore/Sabrient Stealth ETF (STH) into Claymore Wilshire Micro-Cap ETF (WMCR).  I contacted Claymore at the time to ask for an explanation.  I was told that they chose the cosmetic surgery option because of the  “critical mass” behind STH and the “cost benefits” of not having to close one fund and open another.

In September 2010, Guggenheim had assimilated its new acquisition enough to drop the Claymore name from most products.  UBD and ULQ were left out of the rebranding, making me speculate something unusual was in the works.  Indeed it was.

Guggenheim Enhanced Core Bond ETF (GIY)is now an actively-managed ETF that attempts to outperform the Barclays Capital U.S. Aggregate Bond index.  The fund’s advisor (Guggenheim Funds Investment Advisors, LLC) uses a quantitative strategy which attempts to identify and capitalize on relative mispricing of securities.  GIY has a stated expense cap of 0.27%, but there are many expenses that fall outside this cap, producing actual net operating expenses of 3.66% (a cap that’s not a cap).  Additional information is on the GIY overview page.

Guggenheim Enhanced Ultra-Short Bond ETF (GSY) is now an actively-managed ETF.  Its low-duration strategy seeks to outperform the 1-3 Month Treasury Bill Index.  GIY has a stated expense cap of 0.27%, but there are many expenses that fall outside this cap, producing actual net operating expenses of 3.37% (another cap that’s not a cap).  Additional information is on the GSY overview page.

To do what they are doing with actively-managed ETFs, Guggenheim must have received exemptive relief from the SEC.  They apparently elected to keep the news quiet until now.  The February 2008 launch date makes GIY and GSY the longest-living actively-managed ETFs in existence.  Both have 3-year track records but were not actively managed for most of that time.  Be sure to read the footnotes if it sounds like they are claiming otherwise.

Bottom line, it appears to me that Guggenheim has not taken any steps to change the tricks employed at Claymore in the past.  In fact, they may even be taking the game to a new level with their expense cap disclosures.

Disclosure covering writer, editor, and publisher:  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.

Numerous hypothetical examples attempt to “prove” that leveraged funds will lose money over time.  To paraphrase a famous line: “Hypos?  We don’t need no stinkin’  hypos.”  Why use hypothetical examples when we have real-life actual examples right in front of us?

Today we will examine the performance of leveraged performance over more than one day.  This is not rocket-science.  It is elementary school math.  So in our real-life example I will call on some old friends from elementary school: Dick and Jane, and their dog Spot.

Being just a dog, Spot doesn’t know much math so he just follows the prevailing price, which is why it is called the “Spot” price.  We will use silver to illustrate.  The iShares Silver ETF (SLV) doesn’t buy stocks; it holds actual bars of silver in an attempt to track the spot price.  Therefore, SLV will represent our Spot.

Dick is in the second grade.  He is learning to multiply by 2, though sometimes he still struggles.  Dick is no dummy, though; he knows he can use first grade addition to add a number to itself and get the same answer as multiplying by 2.  Dick likes to chase Spot but needs to move twice as fast since he has only two legs to Spot’s four.  Therefore, Dick moves twice as much as Spot (SLV) every day, just like ProShares Ultra Silver (AGQ).

Young girls often seem smarter than boys, and Jane is no exception.  Not only has she mastered how to multiply by 2, she also knows about negative numbers.  At that age, many girls also want to act the opposite of boys.  No special reason why – just because.  Therefore, instead of chasing Spot every day like Dick does, Jane decides to move twice as much in the opposite direction.  Therefore, we can think of Jane as ProShares UltraShort Silver (ZSL), which moves twice the opposite of Spot (SLV) every day.

Now we will review Spot’s (SLV) activity over four days last week.  We will also keep tabs on Dick (AGQ) and Jane (ZSL) to make sure they are doing their arithmetic correctly.  Dick, Jane, and Spot live together on a hill.  Every day, Spot decides to run either up the hill or down the hill.  Dick chases Spot at 2x (+200%).  Jane does the opposite by moving 200% opposite of Spot. 

For the past few months, Spot would take off running up the hill nearly every day.  On Monday, May 2, Spot surprised Dick by running 8.6% down the hill.  Dick used his first grade addition to determine he needed to go 17.2% down the hill.  Jane knew she needed to go 17.2% up the hill.  Neither was accustomed to Spot moving that much in one day, and due to some rounding errors Dick went 17.4% down while Jane went 16.6% up.

Spot realized that running downhill was easier than going up and decided to do it again Tuesday.  Spot ran 5.3% down.  Dick doubled that by running 10.6% down.  Jane tried to do the opposite but went uphill only 10.1%.  Wednesday was a near repeat of Tuesday with Spot down 5.7%, Dick down 11.6%, and Jane up 11.1%. 

Spot began to realize just how hard it would be to knock Dick and Jane off their mission.  On Thursday, Spot decided it was time to go for a new record and ran down the hill 11.9%.  Dick had never been called upon to move that far before, but he managed to go down 23.4% that day.  Jane was up to the task, moving 25.1% up the hill.

It was a wild four days and Spot traveled a great distance.  However, to find out how far Spot traveled, we cannot simply add the percentage moves together.  We need to use daily compounding.  By comparing his ending point to his starting point, we determine that Spot went 28% down the hill over those four days.

Lazy Larry, Dick and Jane’s neighbor, is always looking for short cuts and refuses to use more than first grade arithmetic.  Lazy Larry tried to determine Spot’s four-day move by simply adding the percentages together.  However, that does not work, yielding an incorrect answer of 31.5% down.

Lazy Larry eventually learns that the correct answer is 28%, and then once again uses his lazy approach to determine that Dick must be 56% down and Jane 56% up.  Another neighbor, Doubting Thomas, claims this cannot be correct because the leverage used by Dick and Jane will make them both lose ground over time.  Therefore, explains Thomas, Dick’s loss must be greater that 56% and Jane’s gain must be less than 56%.

Just like Spot’s 4-day move cannot be solved by adding four percentages together, Dick and Jane’s 4-day moves also cannot be determined so easily.  Daily compounding must be considered.  For Spot, the detailed math is (1-8.6%) x (1-5.3%) x (1-5.7%) x (1-11.9%) -1= -28.1%.

It turns out that when we apply the correct formula, both Dick and Jane came out better than Lazy Larry and Doubting Thomas had predicted.  Instead of losing 56% or more, Dick (AGX) only lost 50%.  Instead of gaining 56% or less, Jane actually gained 78%, even after falling short of her goal on each of the first three days.

The table below shows the life of Dick (AGX) and Jane (ZSL) and Spot (SLV) during four days in May.  This is how leveraged funds with daily reset work.  Don’t be a Lazy Larry or Doubting Thomas.  Take the time to study this real life example.  The math is not all that complicated.  If Dick and Jane can do it, you can, too.

Disclosure covering writer, editor, and publisher:  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.

During the nearly two-month closure, many investors mistakenly assumed the Market Vectors Egypt ETF (EGPT) was a good proxy for the Egyptian stock market.  I pointed out what I saw as the fallacy of that view in my Impending Collapse of the 30% Premium for EGPT article.

Instead of jumping 30%, the NAV for EGPT dropped -7.3% overnight to $15.31 as Van Eck deployed the 41% cash stake that had built up while Egypt was closed.  Trading in EGPT closed at $16.65 yesterday and was halted before the market opened this morning.  Trading commenced one hour later with the price dropping to $15.26 – the premium totally collapsed and a slight discount was momentarily available.

EGPT traded for $19.21 just 10 market days ago – a +25.5% premium to today’s NAV.  Much of the price collapse occurred yesterday as traders learned of the reopening of markets in Egypt.

According to a BBC article, the reopening of Egypt’s market was forced by MSCI (Morgan Stanley Capital International) indexing rules which would have eliminated all Egyptian companies from various MSCI indexes due to lack of trading.

Van Eck’s EGPT website provides the latest information on the fund’s holdings and cash levels.  Van Eck has not stated when they will resume share creation and redemption for the fund.  My article EGPT Now 50% Cash With A Hefty Premium For That Cash warned investors of these events and the potential implications.

Disclosure covering writer, editor, and publisher:  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 never understood why PowerShares changed the ticker symbol on the Nasdaq 100 ETF from QQQ to QQQQ while simultaneously making QQQ part of its name back in 2004.  Perhaps it had something to do with it becoming a Nasdaq listing when the Nasdaq wasn’t allowed to have three letter ticker symbols.  Anyway, apparently enough time has passed (or the letter count restrictions were relaxed enough) to allow it to revert to the former ticker – the one with just three letters that matches its name.

As we reported earlier, PowerShares and SPDR Trust settled their lawsuit with PowerShares agreeing to change the tickers on their small cap sector suite.  The SPDR Trust alleged that PowerShares infringed on its trademark by using ticker symbols containing the letter “XL”.  The PowerShares small cap sector ETFs originally used ticker symbols that added an “S” to the end of the symbols used by the Select Sector SPDR Suite.

The 10 affected funds that will have new ticker symbols on Wednesday (3/23/2011) are:

Disclosure covering writer, editor, and publisher:  long QQQQ/QQQ.  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.