ETF Dangers How To Conquer Them Houston Investors Association & 1/19/13 ETF Dangers & How To Conquer Them Ron Rowland InvestWithAnEdge.com Austin, Texas

Ron Rowland President, Capital Cities Asset Management Investment Management Services Editor, AllStarInvestor.com Publisher of subscription newsletters Founder, InvestWithAnEdge.com ETF analysis and market commentary

& How to Avoid Them 2) Execution Dangers 3) Structure Dangers ETF Dangers & How to Avoid Them 1) Liquidity Dangers 2) Execution Dangers 3) Structure Dangers Q & A

The ETF 92-8 Rule 80-20 Rule: “80% of results are from 20% of the activity” For ETFs/ETNs: 92% of $ Volume is from just 8% of funds 36.4% SPY SPDR S&P 500 5.5% IWM iShares Russell 2000 4.7% QQQQ PowerShares QQQ 3.7% EEM iShares MSCI Emerging Markets 2.9% GLD SPDR Gold Trust The top 8% (~115) are also referred to as “the vital few”

ETF Liquidity Tiers 4Q-2012 ADVT The Vital Few Deathwatch $ Billion Club

What Makes an ETF an ETF? ETFs are unique: not mutual funds, not closed-end funds, not stocks The ability to create and redeem shares via in-kind exchange is key to the operation of an ETF The in-kind exchange process allows the price to track the NAV through arbitration If price < NAV: sell stock & buy ETF shares If price > NAV: buy stock & sell ETF shares

Liquidity Dangers B/A Spreads ADVT ($ Volume) Underlying Markets

Do not accept B/A spreads at face value. Look at B/A depth. B/A spreads have both an “advertised spread” and a supported or “liquidity spread”. Example: RSX Depth Screen shot – next slide DANGER Do not accept B/A spreads at face value. Look at B/A depth. Use limit orders. SOLUTION

Example of Misleading Bid/Ask Spread Advertised B/A = 44.31/44.35 .04 Supported B/A = 44.18/44.48 .30

Do not use “Market on Open” or “Market on Close” orders. B/A spreads are often very wide when the market opens and sometimes just before close. Example: iShares Nasdaq Biotech (IBB) B=83.03 A=84.35 1.32 (at open) B=83.75 A=84.27 .52 (1 min later) B=82.20 A=82.24 .04 (mid-day) DANGER SOLUTION Do not use “Market on Open” or “Market on Close” orders. Wait until B/A spread is being managed

B/A spreads are often at ridiculous values during after-hours trading. Example: iShares DJ US Medical Devices (IHI) B=58.99 A =67.39 Spread = 8.40 DANGER Do not trade ETFs after-hours. If you must trade after-hours, then always use a limit order. SOLUTION

Do not trade ETFs that are on our ETF Deathwatch list. Some ETFs can go for days without any trades occurring. You may not be able to sell your position in a timely manner. DANGER Do not trade ETFs that are on our ETF Deathwatch list. Trade only 100 shares and be willing to accept the B/A spread. SOLUTION

ETF liquidity is a function of the liquidity of the underlying stocks. Even thinly traded U.S. ETFs may have better liquidity than higher volume international ETFs. DANGER Trade European ETFs in the morning for best liquidity Remember that there is no overlap with Asian markets SOLUTION

Execution Dangers Market Orders Stop-Loss Orders Transaction Costs

Only use market orders on the most liquid and high volume ETFs. Do not use “market orders” on transactions that are larger than the advertised number of shares at the B/A spread. Example: PHO screen shot – next slide DANGER Use limit orders. Only use market orders on the most liquid and high volume ETFs. SOLUTION

Example of “Buy at Market”

Market on Open orders and Market on Close orders may not have the desired effect. Example: The B/A spread is wide at the open/close The “open” is unmanaged for most ETFs. DANGER Do not use “Market on Open” or “Market on Close” orders. Use limit order if trading near the open or close. SOLUTION

XLP close at 24.15 11/06/08 Example of “Market on Close”

Use “mental” stop-loss or computer alerts. Avoid “stop-loss” orders, especially on thinly traded and international ETFs. Overnight gaps are often exaggerated. DANGER Use “mental” stop-loss or computer alerts. Place orders manually. SOLUTION

Another reason to not use stop-loss orders Flash Crash – May 6, 2010 Another reason to not use stop-loss orders

Structure Dangers Tracking Leverage ETNs

ETFs may not track what you think they should track. Example: Crude-oil ETFs 3/30/07–8/31/07 +12.4% spot price change for WTI crude +7.9% MacroShares Up Crude Oil (UCR) +5.5% iPath S&P GSCI Crude Oil (OIL) +4.6% United States Oil Fund (USO) -1.9% PowerShares DB Oil (DBO) DANGER Look beyond the name of the ETF to see if futures used. Avoid future-based ETFs when underlying in contango. Use for day-trading in non-roll weeks. SOLUTION

Hypothetical Contango Example Contango occurs when next contract costs more than expiring contract. Spot Price Index ETF based on futures with monthly contract roll while in contango

ETFs may not track their index. Example: In late 2007, the securities regulator of India placed a halt on purchases by foreign investors. iPath MSCI India ETN (INP) was trading at a +15% premium to the indicative value. It had essentially become a closed-end fund. DANGER Compare the ETF’s trading price to its Indicative Value. The IV symbol typically uses the following format: $INP.IV (for INP on eSignal) ^INP.IV (for INP on Yahoo) SOLUTION

Indicative Value is meaningless when the underlying market is closed. Example: iShares S&P Europe 350 (IEV) Price closely tracks IV while Europe open Price deviates from IV once Europe closes DANGER Trade European ETFs in the morning for best liquidity & tracking Remember: there is no overlap of US and Asian markets SOLUTION

Indicative Value when underlying mkt closed

Leveraged and Inverse ETFs may not perform the way you think they should over periods longer than a day. Example: DirexionShares 3x Financials Bull (FAS) and 3x Financials Bear (FAZ) can both go down in value DANGER Do not buy leveraged or inverse ETFs unless you fully understand how they work Have an exit plan SOLUTION

Some equity and commodity ETPs contain credit risk. Example: ETNs – Exchange Traded Notes are essentially bonds that are linked to an equity, commodity, or other index. You are therefore at risk of issuer default. DANGER Favor ETFs over ETNs Only buy ETNs based on issuer names you can trust. A default would likely put them out of business. Should not happen overnight. SOLUTION

Know the bond issuer and monitor its financial health ETNs – Exchange Traded Notes are essentially bonds that are linked to an equity, commodity, or other index. You are therefore at risk of issuer default. DANGER Three ETNs were backed by the full faith and credit of Lehman Brothers (bankruptcy): - Opta S&P Private Equity Notes ETN (PPE) - Opta Lehman Agriculture Pure Beta ETN (EOH) - Opta Lehman Commodity Index ETN (RAW) SOLUTION Know the bond issuer and monitor its financial health

Sometimes the marketing material doesn’t tell the whole story. DANGER Sometimes the marketing material doesn’t tell the whole story. Examples: UBS Gold-Hedged S&P (SPGH) – says half in gold & half in S&P. Leaves out that each half is 100% and that it is a 200% leveraged fund. Alerian MLP ETF (AMLP) – says will track index minus expenses. Leaves out that 37.5% of gains withheld for the fund’s corporate taxes are part of the total expenses. SOLUTION Understand what you are buying

Closure Dangers Tracking Fees No liquidation

What to do if your ETF closes Deathwatch What to do if your ETF closes

Avoid Termination Fees Sell Immediately to Avoid Termination Fees MacroShares Major Metro Housing Up/Down charged shareholders early termination fees $0.85 - $0.90 per share (~ 3.5% of share value) Annualized expense ratio for UMM/DMM > 12.5%

Sell Immediately to Avoid Tracking Error Some funds begin liquidation immediately upon closure announcement Fund will not be able to track its objective (target index) during this period You don’t really know what you own Example: On 7/23/2009, XShares announced intentions to close the AirShares EU Carbon Allowance Fund (ASO) effective July 31, 2009 and that liquidation would begin immediately.

Sell Immediately to Avoid Non-Redemption Funds may choose to delist but not liquidate Creation/redemption process removed No active bid/ask Your shares are stuck in limbo 3 Credit Suisse ETNs now trade OTC Elements MLCX Gold Index ETN Elements MLCX Livestock Index ETN Elements MLCX Precious Metals Index ETN

Avoid Opportunity Risk Sell Immediately to Avoid Opportunity Risk The liquidation/redemption process usually takes 3-5 days, but there is no guarantee You might save a transaction fee but: Your money will not be invested You will not have access to your money You will be unable to take advantage of other opportunities

Avoid Termination Process Sell Immediately to Avoid Termination Process If a fund you own announces a closure: Determine fair value (indicative value ticker) 2. Sell shares with a “limit order” 3. Be patient, may take a couple of days to fill 4. Monitor the process, adjust limit if necessary

& How to Conquer Them 1) Liquidity Dangers Focus on larger ETFs ETF Dangers & How to Conquer Them 1) Liquidity Dangers Focus on larger ETFs 2) Execution Dangers Always use limit orders Structure Dangers Know what you are buying 4) Closure Dangers Avoid liquidation process

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Disclosures Past performance is not a guarantee of future results. All investments involve risk and there is always the possibility of incurring a loss as well as the potential for profits. Ron Rowland, along with clients and employees of CCAM, utilize the strategies presented here and will typically hold positions in any securities recommended. Performance data for Capital Cities Asset Management (CCAM) examples are based on the composite of all accounts under management that were in the referenced investment program for the entire quarter and includes reinvestment of all dividends and distributions. Reduction due to management fees has been accounted for. The performance of individual accounts will vary from the composites presented. Performance results for All Star Investor are not representative of those achieved by clients of CCAM due to differences in security selection, timing of trades, transaction fees, and CCAM’s management fees. It should not be assumed that investments made in the future will be profitable or will equal the performance of the securities mentioned or that the mentioned investments were or will be profitable. The securities discussed do not reflect all recommendations in this investment category, but a complete list of recommendations for the past year will be provided upon request.