In 1776, Adam Smith introduced the term “invisible hand” in his Inquiry into the Nature and Causes of the Wealth of Nations, the first book in modern economics. He devised the term to indicate that a spontaneous order was created when all persons act in their own interests, keeping to ethical behaviour.

In recent months, all markets–every market in the world: stock indices, fixed-income securities, currencies and commodities–have been exceptionally volatile. The markets and the usual tools are a sort of attire that has become too light for an increasingly frigid climate. We need to put something warmer on our backs, and the invisible hand is now offering us tools that seem to be available at just the right time. They enable us to benefit more quickly from rises and falls in prices, which are occurring at a more rapid pace. These tools let us participate in non-equity markets–in areas such as gold, oil and agricultural products –that have become hot.

In Canada, following the U.S. example, the invisible hand has created 14 of these new exchange traded funds: seven bull funds and seven bear funds (they have been developed by Horizon BetaPro Funds, ETF section). They did not just spring up today, but they are recent, with some of them barely a few months old.

These tools have multiple aims: to create a new form of diversification, to offer faster gains, and to provide a sort of price insurance for your portfolio. These second-generation ETFs are RRSP-eligible, as are the first-generation funds. “Second generation” is used here simply to distinguish these new products from others dating further back that came into being as a passive response to conventional stock indices. A classic example of a first-generation ETF is the XIU, the symbol for the S&P/TSX60 index. There are many of these older products, for which the XIU is the prototype. Investors who are not yet fully familiar with them can discover them on the Ishares website (Canada and U.S.).

The second-generation ETFs are more complex than the previous ones: they rely on derivatives (futures and options), and they offer to make money twice as quickly, before fees, not only in a bull market but also in a bear market. Management fees are higher: managers must have financial engineering knowledge, whereas the XIU and other first-generation funds are simply carbon copies of existing stock indices – the same stocks, the same weightings, and no derivatives.Table 1 shows these second-generation ETFs, currently available in Canada.

Table 1. Second-generation ETFs (with their symbols)

I am splitting the ETFs in Table 1 into two families: stock indices (all the S&P/TSX indices) and commodities (the others). This split reflects the different nature of the underlying products that, in turn, require different strategic approaches.

The ETF stock index family reflects what on average becomes a certainty: over a period of decades, indices go up since they represent the work and progress of an entire country and are the sum of all our efforts, projects, visions and concerns. Even in the shorter term, a stock index offers extraordinary upside opportunities. For example, investors who bought XIU shares in 2003 at $30 found themselves five years later with shares worth $90, with no effort. This is enough to humiliate all those financial engineers who created alternative funds! In the behaviour of these indices, there may naturally be series of negative months, after which the profit accumulated previously can dwindle or disappear.

After all is said an done, the basic strategy is always to remain faithful to a stock index such as the XIU, but today this can be done with variants, thanks to the new ETFs.

To see how these work, I have taken the HXD, one of the most popular indices if we are to judge by daily trading volume, and I have compared it to the XIU graph (see Graphs 1 and 2 below). In the symbols for these new ETFs, the last letter indicates whether they make a profit on the downswing (D) or on the upswing (U).

You can see that the two graphs are each other’s mirror image, turned 180º. I then put the size of the coinciding fluctuations of these two instruments in Table 2.

Table 2. Behaviour of the XIU (S&P/TSX60 index) and of the
HXD). See Graphs 1 and 2.

past performance may not be repeated

Two conclusions can be drawn from this. First, it can be observed that these two instruments have a high correlation: if the HXD is rising, the XIU is falling, and vice versa. Second, it can be seen that the adverse fluctuation of HXD shares is only about half that of XIU shares.

Neither tool is the exact mirror of the other, even though their degree of similarity is high. This difference is due to the fact that the XIU is a true stock-based index, whereas the HXD uses futures and options in the index to simulate the original. Its response is never identical to the original for reasons of structure and choice of tools. To these differences must be added management fees, which are higher for second-generation ETFs.

Table 2 suggests two types of strategies: coverage and scalping (a term indicating an intention to profit from any price fluctuation).

Coverage strategies: If you have 1,000 XIU shares and the trend is downward, instead of selling XIU while awaiting an upswing, you can:
• Hold the XIU shares and buy 1,000 HXD shares.
• Hold the XIU shares and buy 2,000 HXD shares.

Scalping strategies: When the index is heading down, you sell the 1,000 XIU shares and buy, for example, 1,000 HXD shares. In case of a rise, you liquidate the HXD and buy XIU. In this way, you can benefit from market declines with HXD and from rises with XIU. You then become a market scalper. This second strategy always aims for profit. You no longer use HXD as “price insurance” for the XIU investment.

This strategy is just an example. You are in effect opening a Pandora’s box of profit-seeking: instead of 1,000 HXD shares, you could buy 2,000; in a bull market, instead of XIU, you could use HXU which, like XIU, has investment parity in dollars, goes up more quickly, and so on. Of course, the greedier you are in seeking profit, the more risk you take, and the analytical means may be dangerously inadequate. This is why you need the proper tools to make the right decisions. We will see this in August, in the second part of the article.

The EFT commodities family is obviously useful: you can take advantage of price movements, whether up or down, in gold, oil, natural gas or grains. These ETFs, created with commodities derivatives, broaden our horizon of new possibilities. Traditionally, most of us are more familiar with equities and stock indices. It is true, for example, that you can share in rising gold prices by buying gold mining shares, but the result is not the same because it is filtered and deformed by a company’s specific performance.

Unlike the value of a stock index, commodities do not follow an upward trend in the long term. For example, investors who bought gold in the late 1970s at US$800 an ounce have still not recuperated half of their investment’s inflation-adjusted value even at current gold prices. The price would now have to exceed US$2,000 an ounce to reach purchasing power parity with the dollars of nearly 30 years ago.

A strategic approach to these ETFs is speculative, scalping both upward and downward fluctuations with technical analysis tools. In the next article, we will see how they are used.

Charles K. Langford, PhD, teaches portfolio management at the School of Management Science at the Université du Québec à Montréal. He has written several books on the subject.

(This publication is provided for information purposes only and does not constitute an offer or a solicitation to buy or sell any securities products referred to herein.)

¹.Investors can find out why in the work by Charles K. Langford Le manuel du marché à terme, just published by Les éditions Quebecor.

To learn more about ETFs, see the DisnatUniversity tutorial on the subject at www.DisnatU.com/ETF

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Opinions expressed in the articles herein are those of the authors and do not necessarily reflect the views of Disnat.

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