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/.

The key feature making ETFs and ETNs similar is their ability to create and redeem shares via in-kind or cash exchanges.  This ongoing process is the essence of the ETF/ETN structure.  In addition to providing liquidity and tax efficiency, it keeps trading prices aligned with net-asset-values, avoiding (or at least minimizing) the discounts and premiums associated with closed-end funds.

The key feature making ETFs and ETNs different is that ETFs are fully collateralized stand-alone entities, independent of the sponsor, issuer, and manager.  ETNs are senior unsecured debt obligations of the issuing firm.  ETNs own nothing, are not collateralized, and carry the credit risk of the issuing firm.

An important but often overlooked point is that the issuer may be different from the ETN’s sponsor and not identified in the product’s name.  Occasionally, identifying the issuer is straightforward: Morgan Stanley (MS) issues the Morgan Stanley brand of ETNs, and Credit Suisse (CS) issues the Credit Suisse ETNs.

Some firms use brand names.  iPath ETNs are from Barclays (BCS) and ETRACS are issued by UBS (UBS).  Some firms issue ETNs under multiple brands.  For example, JPMorgan (JPM) issues ETNs that carry the JPMorgan name as well as products with the KEYnotes brand.

If you own an ELEMENTS brand ETN, identifying the issuer becomes more difficult.  This is because ELEMENTS is the only ETN sponsor currently using multiple issuers – three different firms in this case.

By my count there are currently 196 ETNs available to US investors, marketed under 15 different brands, and issued by 11 different firms.  The table below can help identify the company to which you are lending money when you buy a given ETN brand.

ETN Sponsors and Issuers

 All data as of 10/31/2011.

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.

Named after the late Senator William Roth of Delaware, the Roth IRA is a federally structured retirement plan.  It usually serves as a supplemental retirement plan to Americans with employer-sponsored retirement plans.  However, it can be used as a primary retirement savings vehicle in certain situations.  A Roth could be perfect for some people.

Several attributes of the Roth IRA distinguish it from other retirement plans.  For one, Roth contributions have already been taxed.  In other words, you cannot deduct contributions in your current tax year with the Roth.  The upside is that direct contributions to those accounts can be withdrawn tax-free at any time.  The real benefit happens after 59½ – when all monies in the Roth IRA are tax-free.

This is the primary difference between Roth IRAs and Traditional IRAs.  Contributions to traditional IRA’s are tax deductible at the time of contribution.  However, you must pay tax on your distributions during retirement.  You decide whether you want to pay taxes now (with the Roth IRA) or later (with Traditional IRAs).

However, not everyone can contribute to a Roth IRA.  Eligibility phases out at certain income limits.  For single filers, you cannot make more than $105,000 to qualify for a full contribution or $105,000-$120,000 to be eligible for a partial contribution.  For joint filers, you cannot make more than $166,000 to qualify for a full contribution.

There are also contribution limits for those who qualify.  According to the IRS,

“If you are under 50 years of age at the end of 2009: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $5,000 or the amount of your taxable compensation for 2009. This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $5,000. The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

“If you are 50 years of age or older before 2010: The maximum contribution that can be made to a traditional or Roth IRA is the smaller of $6,000 or the amount of your taxable compensation for 2009.  This limit can be split between a traditional IRA and a Roth IRA but the combined limit is $6,000.  The maximum deductible contribution to a traditional IRA and the maximum contribution to a Roth IRA may be reduced depending on your modified adjusted gross income.”

Finally, you can contribute up until the tax-filing deadline in the following year.  In other words, for the 2009 tax year, you have until April 15, 2010 to make your contribution.  For those who qualify, the Roth is often the best way to supplement an employer- sponsored retirement program.  401k, 403b and similar programs are still the best place to save your money over the long-term, but a Roth IRA can be a good idea if you’ve maximized those contributions.  Don’t let the Roth IRA be a mystery any longer, and for the record, I’d go with David Lee Roth, too.

On July 10^th, the S&P 500 traded in a range from 873 to 883 with a close around 879.  Today’s high was over 979 – almost exactly 100 points higher in nine trading days.  Call it a silky smooth 11% pop in less than two weeks.  Kowabunga!

Now mind you, if our vacation loving couple were net short, they’re crying over their empty Diet Coke cans.  However, if they’ve been invested, even conservatively, they’ll see a big increase in their net worth.  As an added bonus – their vacation paid is in full, with plenty left over!  Cha-Ching!

Now, here’s the rub.  What should Mr. and Mrs. Nuclear Parent do now?  All they read about in the financial press before vacation was something about a reverse head and shoulder pattern, support cracking, the market shaping up for a big downside move.  Now, the Sunday morning business section will be lathered with bullish spin – better-than-expected earnings, housing recovery, and Fed Chief Ben Bernanke’s magically delicious exit plan.  Go figure!

It’s the sign of the times.  We are now moving from over-sold to over-bought conditions in hours, not weeks or months.  Discussions about “the VIX,” bull/bear surveys, unemployment reports, corporate earnings, changes in the price of gold or oil are all becoming common in our hyperactive investing society.  We have engineered a bi-polar investing world!

Have the capital markets evolved from an investment organism into a trading organism?  Do prices reflect fundamentals, or is perception all that matters now?  There are no easy answers.  We are in a bi-polar world.

I think it makes sense, especially in this dangerous market, to maintain a disciplined approach, with heavy cash balances and a skeptical eye toward what the masses on Wall Street are pitching.  We’ve come a long way in a very short time.  And now we’ll hear how the train is leaving the station and you better not get left behind.  I’d be careful not to get caught up in the hype.

We’ve all seen firsthand how this market can swing violently up, down, and then back up again.  Don’t be so sure it’s a one-way ride to Dow 10,000 now.  Good luck.

When the first US-listed ETF, the SPDR S&P 500 (SPY), arrived on the scene in 1993 it had a number of features setting it apart from every other product that come before it.  Yet in some ways it was quite familiar as well.  The fact that it was a fund consisting of many stocks was nothing new; mutual funds had been around for decades.  The fact that it tracked the S&P 500 index did not make it unique; the Vanguard 500 (VFINX) was launched in 1976.  The fact that it was a fund that traded all day on a stock exchange was also nothing new; closed-end funds had also been around for decades.

So what made this product so special?  What set it apart from everything else?  Two features provided the soul of what was to become the ETF industry:

1. First, SPY had an Intraday Indicative Value (IIV), sometimes just called the Indicative Value, Underlying Trading Value, or Net Asset Value (NAV). Additionally, this IIV was updated every fifteen seconds while the market was open. For this to be possible, the fund’s holdings have to be 100% transparent because the actual value of the underlying portfolio can be updated only if the actual holdings are fully disclosed.
2. Second, the first ETF had the ability to create new shares and redeem existing shares through an in-kind exchange process. Since the holdings were known, a large institutional investor (called an Authorized Participant) could put together a basket of stocks that exactly duplicated the ETF’s holdings and exchange these stocks for shares of the ETF (and vice versa).

Now, these two things may not sound like a big deal, but they are.  They are the essence of what makes an ETF an ETF.  The IIV means that traders can determine if the ETF is trading at a fair price any time the market is open. The in-kind exchange process means that the trading price should track the IIV very closely.

This arbitration mechanism is what distinguishes and ETF from a closed-end mutual fund. If an ETF starts trading at a discount to its NAV, the Authorized Participants have a profit opportunity.  They can step in and buy the ETF on the open market, do an in-kind redemption to receive the underlying shares, and then sell the stock, making a profit on the difference.  The Authorized Participants can repeat this process until the discount disappears.

Likewise, if the ETF is trading at a premium to the IIV, the opposite happens: an Authorized Participant exchanges the underlying stock for shares in the ETF and then sells the ETF at a premium, making a profit on the difference.

This mechanism brings another benefit for all shareholder: in-kind exchanges (and therefore Creations/Redemptions) are not taxable events.  This resolves supply and demand imbalances without impacting existing shareholders – a source of significant investor dissatisfaction with traditional open-end mutual funds.

Closed-end funds are not ETFs because they do not have the ability to create or redeem shares through an in-kind exchange.  As a result, their trading price is often at a large premium or discount to the fund’s NAV.

Intraday Indicative Value and share creation/redemption through in-kind exchanges: two simple concepts, yet when combined they become a powerful force – the soul of an ETF.

Contrary to popular belief, leveraged and inverse products that reset their exposure level every day are not new.  Rydex introduced the concept with the launch of Rydex Nova (RYNVX) in 1993 and Rydex Ursa (RYURX) in 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).

However, as more and more leverage is applied in these products, the adverse impacts appear to grow exponentially.  Direxion introduced 3x ETFs in late 2008, and now we have five months of data to look at.

For this example, I have chosen two inversely related leveraged funds: Direxion Financial Bull 3x Shares (FAS) and Direxion Financial Bear 3x Shares (FAZ). The chart below illustrates the returns for the five-month period from 11/6/2008 through 4/6/2009 for the following four scenarios:

1. Green Line: Buy and hold FAS = -86.3%
2. Red Line: Buy and hold FAZ = -76.9%
3. Yellow Line: Buy and hold equal amounts of FAS and FAZ with no rebalancing (what some might consider a perfect hedge) = -81.6%
4. Cyan Line: Buy equal amounts of FAS and FAZ and rebalance every day (a lot of work) = -25.0% (not counting transaction fees and slippage)

Chart and data by www.FastTrack.net

Even if you go to the trouble of rebalancing every single day the market is open, you are still fighting a headwind of 25% for a five-month period.  Most people would consider that impossible to overcome on any kind of continuing basis.

I’ve said it before and I’ll say it again:  Leveraged ETFs can be great short-term trading instruments, but make sure you understand the longer-term impact before holding any of them for more than a few days.

All the ETF sponsors of leveraged and inverse products provide warnings and educational material.  Here are links to such information for DirexionShares, ProShares, and RydexShares.

Disclosure:  no positions

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A minute later, a flurry of buy orders hit.  Apparently, they were all “at the market” buy orders because what happened next can be seen in the screen shot below:

Tick level analysis reveals that this was not one large order but a large series of orders, all less than 5,000 shares each.  However, it may have been just one or two buyers utilizing an algorithm without the limit order option enabled, or a computerized auto-trading program may have run amuck. 

More than 60,000 shares changed hands at prices above $29 (a 10% premium).  Approximately an hour later, a single trade for 47,000 shares took place at $26.08, with no more than a three-cent move in the price.  That’s the power of using a limit order.

Disclosure:  no positions, but considering one (with a limit order)

This week’s survey results saw bullish sentiment fall to 18.92%, below its long-term average of 39.0%. Neutral sentiment fell to 10.81%, below the long-term average of 31.2%. And bearish sentiment rose to an all time high of 70.27%, above the long-term average of 29.8%.

Cowabunga!  After today’s +6.4% move on the S&P 500, will this be viewed as the turning point?  Then again, the S&P 500 last traded at this level (719) just four days ago!!  What a wild market.  Note, we’ve pushed the indices down so much, 379 pts on the Dow Jones Industrials becomes a +5.8% move in one day.  The law of small numbers now works for you. 

Be mindful of the previous support level for the broad market; S&P 740 area.  That now becomes resistance.  If the market can power through that level, there may be more upside ahead.  With sentiment so low, and stocks well off their 200-day moving averages, we’ve been set-up for a rally for quite some time.  What we have noted time and time again is how surprisingly long (and disturbing) it has been since one would have expected an over-sold rally to have already occurred.   When the discussion turns to 666 being the official bottom, and it’s onward and upward from here, recall the following:  These are not normal times.