For many investors, an exchange-traded fund is an easy, inexpensive way to gain exposure to traditional, broad-market indexes such as the Standard & Poor’s 500 index.
Since the first U.S. ETF launched in 1993, the category has grown to include commodity and currency funds, alternatively-weighted funds and, as of 2008, actively managed ETFs. According to the Investment Company Institute, which tracks and analyzes data on mutual funds and ETFs, there were 1,141 U.S.-domiciled ETFs at the end of 2014.
The largest number of ETFs still track major market-capitalization-weighted indexes. But fund companies have rolled out plenty of offerings that track arcane indexes, regions of the world with less-accessible capital markets and narrow slivers of broad sectors. Other products have complicated methodologies, such as leveraged and inverse ETFs, and some use currency-hedging strategies. There are also ETFs that track the performance of a single commodity or follow a trendy concept.
For example, Cameron and Tyler Winklevoss, best known for their lawsuit against Facebook CEO Mark Zuckerberg regarding the company’s founding, are planning an ETF that will track the performance of the digital currency bitcoin.
With so many products available, how can an investor know which may be a good fit for his or her objectives and risk tolerance?
Chris Nicholson, director of communications at FutureAdvisor in San Francisco, says investors should avoid ETFs with complicated strategies. They are often more expensive than traditional indexed ETFs, and investors may not understand the underlying methodologies.
The cost differences between a more exotic ETF and a basic index fund can be dramatic. For example, the actively managed Ranger Bear Equity ETF, which uses a short-only strategy, has an expense ratio of 1.70 percent. Meanwhile, the expense ratio of the SPDR S&P 500 ETF, which simply tracks the S&P 500 index, is only 0.095 percent.
Nicholson cites 2010 Morningstar research that showed fund fees are a strong predictor of performance. “The lowest fees will always be associated with [index] funds. It’s never going to be the gimmicky or complicated stuff,” he says. “The more complicated you get with these funds, the more active you get, and you’re going to be charged more. If we’ve learned anything from [the financial crisis of] 2008, it’s that complex financial products are much more likely to explode than simple ones. If you’re buying something you don’t understand, then you’re more at risk of losing a lot of money.”
Mark Zaifman, founder of Spiritus Financial Planning in Petaluma, California, also urges investors to steer clear of expensive ETFs created to track a theme. He’s particularly leery of products such as leveraged ETFs, which are designed to double or triple the performance of an underlying index, and inverse ETFs, designed to return the inverse performance of the underlying index.
Some of the more esoteric ETFs, he says, are developed by marketers who realize many investors want exposure to trends that are hot at the moment. However, what’s trendy is not necessarily in the best interest of any investor.
“If you’re trying to keep a broad-based asset allocation, do you understand how much leverage and risk is potentially there in these funds? They are created to make people feel like they are buying something sexy — the flavor of the day. If it’s the hottest thing right now, people will want it in their portfolios. But it misses the whole point of investing in a long-term diversified portfolio,” Zaifman says.
Niche ETFs come and go at a rapid pace, and fund companies are fairly quick to pull the plug if a product doesn’t attract investment. Among the many ETFs that closed in 2014 was the Power Shares Dynamic Magni Quant Portfolio, which tracked the Top 200 Dynamic Intellidex Index, a stock index unknown to most investors. Meanwhile, PureFunds shuttered its ISE Diamond/Gemstone ETF and its ISE Mining Service ETF, neither of which drew the investment dollars its parent firm expected.
For investors who think a particularly country or region is poised for growth, or who just want ongoing exposure to a particular world economy, ETFs can be a valid way to add geographic diversification. However, investors must understand the different risk profile of a “frontier” market such as Qatar, Kuwait, Nigeria or Argentina, as opposed to a developed, industrial nation such as the U.S., Germany or Japan.
In October, Recon Capital Funds, headquartered in Greenwich, Connecticut, launched an ETF tracking Germany’s DAX index of blue-chip stocks. Recon managing partner and chief investment officer Kevin Kelly advises do-it-yourself investors to conduct research before choosing any ETF.
“People need to look at ETFs just like they would buying a car,” Kelly says. “See how they perform over different market cycles. Look at the expenses. If there’s a theme or a country you’re interested in, compare all the funds that directly compete. If you’re spending your money, you don’t want to drive off the ETF lot and lose a lot of value.”
Kelly says the marketing of more complex or themed ETFs may give investors a distorted view of how the funds may perform over time. “A lot of these products are designed to sell a niche idea, hoping that people will get on the bandwagon,” he says. “But they were launched for a particular market cycle or time period. They were not around in 2008 and 2009, so we don’t know how they will perform should there be a [market] dislocation.”
For Zaifman, the bottom line is simplicity, a concept often emphasized by Vanguard Group founder John Bogle. “I’ve discovered that people think if an investment is simple, it doesn’t perform well — that it has to be complicated. But that’s not at all true.”
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Investors: Think Twice Before Buying Exotic ETFs originally appeared on usnews.com
