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TheStreet Open House

ETFs: The Most Dangerous

Editor's note: This is the final installment of our series on the 10 Most Dangerous ETFs. Be sure to read Part 1 and Part 2.

NEW YORK ( TheStreet) -- These ETFs have layers of risk heaped onto already complex strategies. Internal and external forces have made them riskier than they outwardly appear, so it is especially important for investors to understand the multiple reasons why these funds are the most dangerous for buy-and-hold investors.

These funds -- United States Natural Gas (UNG), PowerShares DB Crude Oil Double Short ETN (DTO) and the tandem of Direxion Daily Financial Bull 3X Shares (FAS) and Direxion Daily Financial Bear 3X Shares (FAZ) -- can wreck your portfolio.

Most Dangerous ETFs

3. Direxion Daily Financial Bull 3X Shares (FAS) and Direxion Daily Financial Bear 3X Shares (FAZ).

While sophisticated traders may find these funds effective daily hedges for more complex strategies, they can be devastating to buy-and-hold investors who don't understand their objectives.

Volatile markets can erode leveraged strategies over time, a challenge that FAS and FAZ have recently faced. Here's the math problem with leveraged ETFs: These funds are designed to give you three times the return of their underlying indexes on a daily basis.

Each day, these funds "reset," compounding returns over time. Direxion recently executed a reverse split in both of these funds because their prices fell so dramatically.

2. United States Natural Gas. As the Obama administration makes efforts to coordinate regulatory authorities and crack down on commodity speculators, UNG has found itself in the headlines. UNG's complex underlying strategy has been made riskier by regulatory uncertainty. Here are the top three reasons why investors should avoid UNG.

  • The strategy: In theory, UNG and United States Oil are "purer" plays on oil and natural gas prices than other ETFs like iShares Dow Jones US Oil & Gas Exploration (IEO) and Energy SPDR (XLE) that track equities. While UNG is designed to reflect natural gas prices, it tracks the near-month futures contracts for natural gas, not the spot price. This methodology inherently causes the fund to deviate from its objective, a problem that USO has also encountered.
  • Creation confusion: The price of an ETF should reflect the underlying value, or NAV, of the fund. Unlike closed end funds or mutual funds, ETFs achieve their tracking objectives by the creation and redemption of shares.

    Regulatory limits caused UNG's creation process to grind to a halt back in July. As fund managers waited for the SEC to approve more shares, UNG began trading at a massive premium to its underlying value.

  • UNG's future: After a summer of premiums, the SEC has approved additional UNG shares, and the fund managers will begin issuing new shares on Sept. 28. As UNG is once again allowed to operate as designed, the creation of new shares should cause the fund to once again trade in line with its underlying value. This shift should eliminate the premium and pop the UNG bubble.

1. PowerShares DB Crude Oil Double Short ETN.

  • The strategy: DTO tracks a basket of futures contracts and employs leverage to achieve its strategy. Futures are inherently volatile and leverage adds volatility, so DTO can be one wild ride. Since DTO is structured as an ETN, rather than an ETF, it is also exposed to the credit risk of its issuer. In an era where once-solid banks have crumbled, credit risk is more of a concern than ever before.
  • Bad genetics: When DTO was originally released, it was paired with the PowerShares DB Crude Oil Double Long ETN (DXO). On Sept. 9, DXO was shut down by its managers because the fund's size had triggered regulatory limitations. While DTO has yet to achieve the popularity of its former pair, investors in this fund should be wary of a potential shut-down.
  • Regulatory smackdown: As regulators home in on ETFs like UNG and DTO that use derivative contracts to achieve their objectives, DTO could face double the regulatory restrictions in the months to come. Increased position limits, or restrictions on the number of futures contracts a fund can own, would affect both UNG and DTO and impact their creation process.

The Financial Industry Regulatory Authority has also recently issued warnings about the risks of leveraged funds. Additional margin requirements will be imposed on Dec. 1. Since DTO is both leveraged and futures-based, this fund faces double the regulatory uncertainty in the months ahead.

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