I met a gentleman a few weeks ago. I’ll call him David. A pharmacist in his 50’s. Happily single after a divorce decades ago. A great golfer, he has played courses from South Africa to St. Andrews. No children, but he does care for his aged mother, his father having passed away some time back.
Filling prescriptions doesn’t pay as well as it used to but David can see retirement not far off and he has a good-sized portfolio, having saved diligently over the years. A friend from his congregation is a financial advisor and invests his portfolio in mutual funds.
David does not pay much attention until 2008. Then, with his portfolio hurting, he starts asking questions. What am I invested in? How much am I paying?
He discovers that while his portfolio has earned him little, the advisor had done quite well, having placed him in various front-load, back-load, any-and-all-load funds with high MERs. David sells all the funds and fires his advisor. I’d like to tell you that it all turns out for the best, but sadly, things went from bad to worse.
He decided to manage his money himself. He began watching BNN and CNBC at the pharmacy, gleaning tips and ideas in between prescriptions. Before long, he was trading in large-cap blue chip names. With markets rallying in 2009, he made money and gained confidence.
Then one day, an expert came on who recommended an ETF that, in my opinion, should only be sold by prescription, ideally, packaged with a complimentary bottle of Tylenol 3.
Horizons BetaPro NYMEX Natural Gas Bull ETF (HNU) is a product for gamblers, not investors. Like most commodity ETFs where actually owning the physical commodity is not practical, HNU buys futures contracts on natural gas. That by itself is problematic. Commodity futures are normally in a state of “contango.” The contracts that are close to expiry are cheaper than the ones farther out by an amount roughly equal to the cost of storing the gas for one month and paying interest charges. (The opposite of contango is “backwardation” which occurs whenever there is some supply disruption and near term prices spike briefly, before returning to contango.)
HNU buys contracts that mature over several weeks. Just before expiry, it replaces them with a fresh batch. This process alone means that every month, the value of HNU erodes by the amount of contango. Gas prices could go up one month and HNU might still be down.
However, it is HNU’s second quality that makes it toxic for human consumption. For every dollar invested, HNU buys $2 worth of futures contracts. On any given day, HNU’s price move will be about double the move of the gas futures. Each day, HNU must adjust the number of futures contracts it holds to align back to twice its assets. Over a few weeks, especially if markets are turbulent, the adjustments leave HNU’s return complete disconnected from the natural gas price.
Natural gas is currently around $4.50 per million BTU, down 67% from its $13.60 high in mid-2008. HNU is at $5.50 per unit, down 99.7% from its $1,860 high (adjusted for reverse-splits) in 2008. It is certainly possible that gas prices triple and return to their 2008 peak. A move from $4.50 to $13.50 can happen.
In that event, will HNU then return to $1,860? Unlikely, but because of the leverage and the daily adjustments, no one has any idea where HNU will go, not even HNU’s manager. Horizons Betapro explains that HNU’s return for any period other than a single day “will likely differ in amount and possibly direction” from its target. In other words, gas could go north and HNU could go still go south. Also, to its credit, Horizons warns investors repeatedly and in plain language that its leveraged products are only for experienced, active traders. And yet, HNU is the biggest leveraged ETF in Canada, with assets under management of $430 million.
HNU is not the only toxic ETF. As a rule of thumb, investors should avoid all leveraged ETFs and especially leveraged commodity ETFs.
David’s other mistake was too much concentration. His portfolio held just a handful of stocks. HNU itself was about a fifth of his portfolio. He called me to ask if there was anything I could do to bring it back. I recommended some tough medicine to staunch further loss and to make changes to the portfolio that would prevent future disasters. But the pill was too bitter to swallow. David still holds HNU, hoping gas prices will rally and that he will re-coup his loss.
Disclaimer: We do not own and have absolutely no intention of ever owning any of the leveraged ETFs mentioned in this report.
|Benchmark||Natural Gas Index|
|52 Week High||$13.74|
|52 Week Low||$4.68|
|Avg Daily Volume||4.35 Million Shrs|
|Avg Daily Volume ($)||$24.15 Million|
|Total Market Cap||$430.19 Million|
|ETF Annual Fee||1.15%|
|ETF Trading Currency||CAD|
|ETF FX Exposure||USD Hedged to CAD|
|Correlation to S&P 500||14.0%|
|Return to Risk Ratio||Not Available|
|Use of Leverage||2 times leverage|
|Use of Futures||Nat Gas Futures|
|6 month Return||-19.33%|
|1 Year Return||-52.65%|
|2 Year Return||-88.39%|
|3 Year Return||-99.59%|
|Dividend Yield (TTM)||0.00%|
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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.