This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Sunday, August 2, 2009

Exchange-Traded Funds

Last week’s blog exposed some of the underlying problems with Exchange-Traded Funds, or ETFs for short. Among these problems is the fact that many of them are essentially derivatives products. Many astute investors will recall that derivatives were large contributors to the market crash last year.

Also making a huge impact last year was excess leverage (debt) in the financial system, much of which was built-in to these glamorous derivatives products. That is the second problem that many are now noticing inherent with ETFs. Renowned investor Warren Buffett has a saying about leverage: “If you’re smart you don’t need it, and if you’re dumb, you got no business using it.”

Oddly enough, since I wrote my blog for last week, both UBS and Edward Jones have announced that they will be halting sales of leveraged ETFs, due to the problems built-in to these complex financial instruments (Bloomberg). While they may not be frequent readers of mine, it’s good to see that someone shares my opinion.

In other regulatory news, the SEC announced this week that it is putting a permanent end to “naked short selling.” This is a rather complex rule in the markets and I won’t bore readers with a lengthy explanation. However, I did feel the need to comment that so-called naked short selling has actually been illegal for years now. It seems the SEC is just now deciding to actually enforce the rule.

However, this news should prompt some personal thought for readers: Do you really know what it is that you own? And more importantly, do you understand how your investments will react to changes in the investment world?

In addition to his proverbs regarding debt, Warren Buffet also argues that investors shouldn’t buy anything that they don’t understand. This concept applies to both individual stocks for companies in strange industries, as well as complex financial instruments that are understood by only a few select minds on Wall Street.

In the markets this week, we continue to anticipate a violent correction in stocks. On Tuesday we saw what we believe was a sign that stocks may be running out of steam after several weeks of bullish trading.

This is not to say we aren’t still bullish on the market. As numbers continue to come out, it is becoming more and more evident that the economy has slowed its decline and now appears to be in a holding pattern.

While recovery is slow, at least things don’t seem to be getting much worse, with the exception of unemployment. In fact, some sectors of the market are actually improving, albeit at a much slower pace than their decline last year.

In light of recent market action, I feel obligated to reiterate a point that I have made repeatedly in previous articles: Investors today have a vital need to understand the role their financial advisor plays. In this industry, there are some professionals who conduct extensive economic research and endless analytical work in order to recommend investments that fit the circumstances.

There are other people in this business who essentially work from a corporate formula to build portfolios for clients that do not take any consideration for economic conditions. And while there is undoubtedly a place in the world for salesmen, investors need to be extremely careful in understanding where these salesmen fit in to their finances.

We can all be certain that the world has changed since this time last year. The long-held concept buy-and-hold simply doesn’t work anymore. Investors need to adjust to the circumstances that now exist, and their investments need to reflect this change in strategy. What investors need now is an active money manager who conducts their own economic research, invest client funds accordingly, and move them appropriately as circumstances change.

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