What is an exchange traded fund?
Similar to mutual funds, exchange traded funds (ETFs) are companies through which assets of shareholders are pooled to achieve pro-rata ownership of a diversified portfolio. Usually an ETF will seek to replicate the performance of a particular part of the market. For instance, one can find ETFs that mimic the Standard & Poor’s 500, an index of Chilean stocks, long-term government bonds and so forth.
In general, ETFs provide an excellent avenue through which you can obtain a diversified portfolio. Most have very low costs and present well-structured index exposures. Click here to see examples of these ETFs.
Of course, Wall Street could not leave well enough alone. Seeing the growing popularity of investor-friendly ETFs, less investor-friendly ones have sprouted up to suck in more revenue. Some new funds are index vehicles with a benign mission but needlessly high expenses. Many new ETFs have esoteric goals aimed to take advantage of investor fear and greed. Some promise to move in the opposite direction of a particular market. Others profess to rise or fall by a multiple of a specific index. Combined with ETFs that provide exposure to commodities, real estate and currencies, a whole new universe of alternatives has been created.
Why you should avoid non-index, non-equity ETFs
Bad contents make bad funds
ETFs consist of the securities purchased and held within the fund. If the fund invests in vehicles you would not buy directly, you should not invest in the fund. As explained in other chapters, you should not buy ETFs that invest in commodities, currencies (Chapter 22), futures, and options. Also, since you should not try to time the market, stay away from bear market ETFs and anything promising to go up when the market goes down (Chapter 20). Further, since professional mutual fund managers have underperformed indexes over time (Chapter 29), avoid managed, non-index ETFs as well. Similarly, per arguments highlighting bad attributes of their mutual fund equivalents, you should also keep clear of ETFs based on asset allocation, bonds, long/short positions, and target dates.
You should avoid risk, not magnify it
A number of ETFs sell the prospect of moving multiple times the rate of change of a given index. If the Standard & Poor’s 500 goes up 2%, an ETF designed to double the index’s pace should rise 4%. When that happens, holders are happy. But when the market declines, a holder will drop at twice the magnitude…and more.
To create this multiplier effect, these ETFs buy and sell derivatives. These bring on transaction costs, risk, and in the case of options a continual drain of premium. On any given day these ETFs may meet their goals of multiplying returns. Over time, most will drift downward to levels well below the value pure multiplication would indicate.
A good example of this phenomenon is the experience of ticker symbol SDS, the ProShares UltraShort S&P500 ETF. This fund is designed to move in the opposite direction of, and by twice as much as, the change in the S&P 500 Index. Figure 13-1 plots the value of $10,000 invested in SDS from the end of 2006 through March of 2011 – a period that begins and ends with the S&P 500 at the same level. Also shown is the course of $10,000 invested in ticker SPY, the SPDR S&P 500 ETF. This ETF is designed to move in the same direction and at the same pace as the S&P 500 Index. Given the stated goals, one would expect values of these single security portfolios to mirror each other, with SDS moving opposite of, and with twice the magnitude as, SPY.
In reality, SDS performed far worse than expected. In September 2009, when the S&P portfolio was still about 25% below the 2007 starting level, SDS should have been 50% higher. Instead, it had fallen back to its original level. When the S&P portfolio recovered enough to reach its original $10,000 in February 2011, the SDS portfolio should have also been about $10,000; instead it was below $5,000.
Adding risk and reducing returns is the opposite of good investing.
What you should do instead
As part of a proper investment regimen, absolutely consider low-cost index exchange traded funds that invest directly in stocks, without leverage or derivatives. Chapter 48 and Appendix B provide guidance for fund selection. Click here to find guidance on fund selection.
Click here if you are considering bond ETFs to improve your approach.
Avoid all other ETFs.
* Data source: New York Stock Exchange: Closing prices for tickers SPY and SDS.