(photo: Dave Malkoff)

An Exchange Traded Fund (ETF) is similar to an index fund - they are typically not actively managed and therefore (often) have low management fees.  Sometimes when you can’t find the perfect fund for your asset allocation, an ETF will fill that gap.  But ETFs aren’t good for regular automatic investments, because you pay a trading fee each time you buy or sell, just like you would in a stock.  Also, they have other supposedly good features which are useless to regular investors:  you can sell them short, and you can trade them during the day (rather than only once per day with a fund).   Because of these features (and marketing), ETFs have gained popularity in the last couple years, and the flavors available have proliferated.

In watching your portfolio drop in the last year, if you are like most people you are wondering where you can invest your money so it’ll go UP, not DOWN.  Check out the finance.google.com page on most recent days, and you’ll see on the “Top Movers” list is the “ProShares Ultrashort Financials ETF”.  On 3/13 it gained 10% when the Dow was down 1.7%, and I’ve seen it gaining 30% or even 50% in a single day.  So you’re thinking, wow, I need to get a piece of THAT!  It’s a perfect hedge for your portfolio, since when the rest goes down, this goes up… right?

Not so fast.  This ETF is part of a certain class of ETFs which are very risky, volatile investments and shouldn’t be purchased by regular investors like you.  These ETFs have words in the name like: “ultrashort, double, triple, 2x, 3x, bear, bull”.  Something that is “2x”, for example, is designed to return 2x what regular investors would get in the underlying investment (e.g. a “2x S&P500″ ETF will gain 2x the S&P on up days, and lose 2X the S&P on down days.)  How do they do it?  All of these ETFs employ “leverage” to give the prescribed return profile, which means they borrow money so they can invest more.  It’s like investing on margin for regular investors - say you have $1000 to invest, but can borrow another $1000, allowing you to invest $2000.  So that when it goes up 10% to $2200, you give back the $1000, and made $200 or 20% (minus borrow cost) on an investment that only went up 10%.  On the flip side, if the investment goes down 10% to $1800, you still have to give back $1000 and now lost 20% (plus borrow cost) on an investment that only lost 10%. (Lesson: don’t invest on margin.)

Okay you say, but what if I use one of these as a small PART of my portfolio, as a hedge (like owning stocks and bonds together - one goes up, the other down)?  As Jason Zweig from the Wall Street Journal writes, this strategy can (will) backfire.  Due to the large swings in daily holdings values, leveraged ETFs are not designed as long-term investments.  They are for day traders, not investors.  For one example, on Friday the lovely ProShares UltraShort Financials had 31.92million shares traded - but it only has 6.8 million shares outstanding!  This implies an average hold time of 86 minutes.  The article quotes Andy O’Rourke, marketing chief of Direxion Funds, an ETF manager - holding a leveraged ETF longer than a day is “like using a toaster to cook a turkey.”

As usual in investing, you will be rewarded by sticking with the basics and not experiementing.  Reducing ‘oops’ moments will make you richer.

Have any thoughts on ETFs?  Please tell us about it in the comments.

Last year I attended an FPA session on improving your credit score by Oksana at StrategyCredit.  Here are some things I learned, many of which most people don’t know.

Your credit score really just measures the chance you’ll pay someone - essentially how much of a financial risk you are.  They are used for everything from apply for a credit card or mortgage to getting auto insurance or even a job.  A high score means (the credit agency thinks) you have a high chance of paying your bills/loans.

The FICO score, created by Fair Isaac Corp in 1958, is the leading credit score metric.  Here’s what different scores mean:

Fair Isaac’s website has an education section about credit scores and how to improve them, which is really useful, and a must-read.

Here are the components of your score:

• 35% payment history
• 30% amounts owed
• 15% length of credit history
• 10% new credit (lots of new accounts lowers your score)
• 10% types of credit used (not using multiple types lowers your score)

Seven Credit Score Truths

• Missed payments on even 1 card can cause increased interest rates on all of your cards
• “Installment” debt owed (e.g. mortgages, auto payments) does not reduce credit score
• Late mortgage or credit card payments and collection accounts (if paid up) can be removed from your credit report by calling the creditor (credit agencies cannot make these changes)
• Late payment history is removed from the credit report after 7 years
• In general, credit report inquiries drop your credit score - BUT, multiple queries within 30 days do not cause your score to drop (i.e. it’s not bad to shop around your mortgage)
• Paying off student loan doesn’t improve credit score if the loan is current
• Your highest credit balance (ever) is what matters, rather than max credit (your credit card limit)  e.g. a credit card with a 30k limit, but the most you ever charged in a month was 5k, if you charge 5k again in another month it is considered “maxed out” at that point, since you never had a higher balance.  The 30k means nothing.

Building Credit History (can’t get a credit card?)

Building credit can sometimes be a chicken-and-egg problem - you can’t get a credit card without credit history, but you can’t build credit history without a card!  One of the best ways to improve your credit score is to have a long history of always paying off your debt on time.  To start building your history, here’s some ways to get it going if you can’t otherwise get a card:

• Secured credit cards - you pay a certain balance up front, say $500, and then get a $500 limit.  Doesn’t sound all that great, but it is if you can’t get a card elsewhere.  Find one that will send your collateral back after a certain period of time.
• Local bank credit cards - often times local banks or credit unions are more willing to issue cards to ‘new’ chargers

Credit Score Optimization Strategies for Home Buyers

If your score is decent, little ups and downs caused by fluctuating credit card balances, new accounts, inquires, etc aren’t a big deal.  But if you are shopping for a mortgage, your current credit score is very important because it affects an interest rate which can in turn affect your finances for another 30 years or so.  You should do the following:

• Do not open or close accounts (including credit cards)
• Check your revolving accounts balance, keep it low
• Check your credit limits, and your highest balance (based on card history) - make sure cards (including Amex ‘charge cards’) have not been charged near their highest balance limits in the last 1-2 months
• Do not pay off accounts in collection

Remember that shopping around a mortgage doesn’t lower your score!

Fraud and ID Theft

Sometimes you can’t help it - wallets get stolen, cards get left a bars… most times you can just cancel the cards, kick yourself in the shin and get on with life.  But if there are unauthorized charges, here’s what to do:

• File a police report (very important)
• File an affidavit with the creditor
• Get the creditor to delete your name from the account (reporting agency can’t help here)

If you are worried about future stolen cards or your credit report in general, you can use a credit score monitoring service - it costs money, but can be worth it if your credit is fragile.  Check out myfico.com.  Personally, I just order a report from one of the 3 agencies every 4 months on a rolling basis so I always have a pretty up-to-date view of my report.

Any rumors you’ve heard about cards?  Stories about your credit?  Leave it in the comments!

This is the last in a series of posts covering the lessons to be learned from Warren Buffett’s Letter to Shareholders of Berkshire Hathaway.  [See Part 1 (on the economy) and Part 2 (on investing)]

On home ownership:

Home ownership is a wonderful thing. My family and I have enjoyed my present home for 50 years, with more to come. But enjoyment and utility should be the primary motives for purchase, not profit or refi possibilities. And the home purchased ought to fit the income of the purchaser.

This backs up a belief I’ve developed over the last couple years - a home is a place you live, and not an investment.  Investing should be done objectively; very rarely are home’s bought and sold objectively.  Investments are purchased only the time is right (cheaply priced, hopefully); Houses are purchased when they are needed (e.g. a family grows to large for the space, or a new job is in a new location.)  Investments are (supposed to be) sold as soon as the required gain is attained, or loss threshold is reached - but it’s not possible to do this with your house, due to the emotion and inability to sell at a moment’s notice, not to mention you still need a place to live.

Remember: It’s always best to separate emotions and investing.