ETFs Offer Incredible Benefits...with a Dark Side

By Darwins Money on 6 December 2010 (Updated 16 December 2010) 2 comments
Photo: Our Update

Exchange-traded funds (ETFs) are simultaneously one of the best financial innovations retail investors have seen in decades, while at the same time misunderstood on a grand scale. While I've enjoyed the benefits of investing with ETFs and consider myself to be at least a moderately sophisticated investor, I've also fallen prey to faulty assumptions and expectations for certain ETFs. Rather than paint the whole ETF category with a single brush, I want to highlight some of the specific misunderstandings I and others have had so that you can be more confident and informed about what you're looking for in an ETF. Some of these examples may save you from a regretful mistake down the road.

Don't Buy the Name (or the Ticker)

Something people don't often think about is the notion that the names and ticker symbols of ETFs are kind of like giant billboards saying "Buy Me!" As someone who follows the industry relatively closely, I often see new ETFs launch based on sensational headlines. For instance, shortly after the story broke that China was restricting export of rare earth metals needed for everything from GPS systems to military applications, there was a mad rush into any name tied to the mining of rare earth minerals. For example, while the launch of this Rare Earth Metals ETF was timed perfectly with headlines invoking panic, the makeup of the ETF isn't exactly a pure play on these metals at all (hence, the name also includes "Strategic Metals," whatever that means). Many of the companies in the top holdings also mine other materials that aren't rare earth metals. Surely, thousands of investors jumped into that investment thinking they could exploit the news that China was blocking exports of these critical materials, only to find later that the ETF wasn't very representative of that asset class.

ETFs are often given memorable ticker symbols as well. Consider the Market Vectors Agribusiness ETF (MOO) and Claymore/MAC Global Solar Energy (TAN). While the catchy ticker symbols may be cute, perhaps the makeup of the ETF, the expense ratio, or the strategy isn't actually your best option in that space — but you'll sure remember that ticker symbol!  And that keeps investors coming back, it gets the ETF mentioned on CNBC, and it makes it tough to get out of your mind. The reason I share those examples is to illustrate that aside from being a basket of stocks, commodities, debt instruments, or any asset class for that matter, these ETFs generate income for the custodian or parent company by way of shares transacted. When they're competing against three other ETFs with essentially the same investment strategy, they need to be innovative in how they market their product. So be careful, be selective, and do a simple search in Google Finance or Yahoo Finance to see if there are other ETFs in the same sector that are a better fit for you.

Understand How ETFs Work

One of the biggest complaints about ETFs is that they didn't perform the way the investor expected them to. This isn't just a retail investor complaint, but even professional money managers are routinely involved in litigation accusing ETF companies of deceptive practices and improper disclosure. The most prominent complaint today is the performance of leveraged ETFs. People erroneously assume that three-times-daily leveraged (3X) ETFs will have returned about triple the underlying index over time. They don't. Aside from the fact that it's three times as painful on the way down, even if the underlying index is flat or slightly up, over long periods of time, leveraged ETFs experience value decay due to daily resets. This is a mathematical certainty that I learned too late as an early investor in leveraged ETFs. To demonstrate the point, just match up any two opposing (long/short) ETF pairs in Google Finance and over a year or longer period, they'll almost always both be negative. If you're wondering how both a long 3X and a short 3X ETF could both lose money at the same time, it's due to this daily reset value decay.

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Don't Overpay

There are a few ways you could end up paying more for an ETF than you thought. First off, make sure you know what the expense ratio is for your ETF. For a basic broad-market ETF, you can often get below 0.15%, especially with Vanguard ETFs. For something a little more sophisticated, expenses are typically in the 0.4% to 0.8% range. Paying over 1% in fees is probably unnecessary as there are often competing ETFs with lower fees or the strategy may not be worth the additional costs in the long run. Since most ETFs aren't actively managed, it's tough to justify commissions in the 1.5% and higher range, but they are out there.

Beware of Low-Volume ETFs

Another problem with many ETFs arises when they are relatively obscure and thinly traded.  In this case, there's a very wide bid-ask spread. This means there's a gap of several cents between what you pay for an ETF and what you can sell it for. If there's a 30 cent gap between the bid and the ask price, and you bought 1,000 shares in a typical market order, you basically just lost $300 the moment you bought the ETF. To avoid this problem, check out the bid-ask spread when trading and focus on higher-volume ETFs. High-volume ETFs often have a bid-ask spread of a single penny, very much like a typical high volume stock.

Watch Out for Tax Demons

Many investors buy first and research later. This is especially troublesome from a tax standpoint for certain classes of ETFs. For instance, an ETF holding Master Limited Partnerships (MLP) might be appealing due to its high yield. But because of the MLP tax structure, investors need to file an additional tax form called a K-1. Not only is this an added level of complexity at tax time, but it also comes very late in the spring, forcing you to file your taxes in March or even as late as April, as opposed to earlier in the year when you would have everything else in order had you steered clear of this asset class. Another example of a tax demon is that if you buy the gold ETF (GLD), you have to pay the higher ordinary income tax rate instead of the capital gains rate when you sell because gold is taxed as a "collectible" under IRS rules. These are just a few problems investors encounter with exotic ETF classes. If you're unsure of tax implications, do some research, read the fact sheet on the ETF homepage, and make sure you won't be surprised come tax time.

In summary, I think ETFs are great instruments for retail investors, and they open the door to many new asset classes, strategies, and ways to diversify portfolios. They are also generally less expensive than mutual funds, trading stocks, and other asset classes individually. However, without reading the fine print, investors are often disappointed with the results, which is why ETFs are starting to get a bad rap. Since one of the best benefits of an ETF is the low fee structure, you can take that a step further with Commission-Free ETF Investing to get the best of both worlds.

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Guest's picture

Good article. If investors aren't doing their homework and blindly investing in ETFs, it really isn't the ETF's fault for not meeting those expectations. If you're an investor, your money is your lifeblood. Do it the courtesy of understanding the risk you're putting it in.

Darwins Money's picture

I agree completely. There are numerous lawsuits out there for what I believe to be just sloppy research and fact-checking, but these ETF companies have to defend them nonetheless. Admittedly, I came up with some whacky leveraged ETF/option combo model years ago and I thought I had a sure thing, only to find out months later about the value decay that occurs. I just didn't spend the time to read the fine print - or articles like this :>