Off the Mark on ETFs

NEW YORK ( TheStreet) -- A few weeks ago I was on "Street Signs" for a segment about income investing. I got a good teasing from friends for saying "maybe you don't get it" in response to Herb Greenberg's protestations to the contrary throughout the segment.

Fast forward to this week and his witch hunt of ETFs. As much as he knows what questions to ask about individual stocks, I don't think he is asking the right questions about ETFs. This matters because I think he bends a lot of ears, but asking the wrong questions does not advance the conversation.

Maybe levered and inverse funds should have a cigarette-like warning on them but to the segment the other day and the question what purpose do they serve, they serve the same purpose as many other investment products: hedging and speculation and people use them for both. Hedging and speculating are neither bad nor good but are instead suitable or unsuitable based on the knowledge and tolerance for the end user. This is no different than other products.

If someone speculates with an option, they take on the added element of being wrong by a day causing the entire bet to go to zero -- meaning the catalyst doesn't occur until one day after expiration.

If someone speculates with a margin account they take on the element of being too leveraged into a massive and fast decline resulting in negative equity. This means after selling you out like a margin call, you owe the brokerage firm more money.

The levered and inverse fund may be of no use to you at all, but does that mean they should not exist? The only ones that should not exist are the ones that are not of any use to anyone. Whether or not the warnings that get slapped on them need to be toughened or people should fill out some sort of options paperwork is a different conversation entirely than what purpose do they serve and should they be abolished.

There is far more leverage with options and futures contracts but for some reason there are not calls to eliminate them.

Also coming under fire from Herb were niche equity funds, specifically the Global X Lithium ETF ( LIT). This fund owns mostly materials stocks in a narrow segment of the market. The fund is neither good nor bad; it is a plain vanilla proxy for an investing theme and yet another choice to add to a short list of individual stocks.

LIT is not the tail wagging the lithium industry dog as alleged by Herb. LIT trades 40,000 shares per day or about $600,000 in dollar volume. Sociedad Quimica Y Minera, FMC ( FMC) and Rockwood Holdings ( ROC) combine to make up 50% of the fund and each stock trades many times that dollar figure.

What about wagging the dog of some of the smaller holding like Reed Resources which is about 2% of LIT and small cap stock in Australia? Based on the average trading volume of LIT, the ETF would account for $12000 worth of Reed (2% of $600,000) compared to a dollar volume on the ASX of $100,000.

It is possible that any ETF where three stocks comprise such a large portion of the fund is not a suitable investment for certain investors. That is a good question for anyone interested in the lithium space but is not a reason to outlaw the fund and it still takes less single-stock risk by definition.

Investors have always misused investment products. Options and margin accounts used to get more notoriety in this regard but now it is more popular to vilify ETFs. If we got rid of ETFs today, then the greed factor that leads to misusing a product will emerge in some other product because there will always be some segment of the investing public trying to exploit what they believe is their edge and many of those folks will simply be wrong.
At the time of publication, Nusbaum nor his clients did not have a position in any of the equities mentioned.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.