Exchange Traded Funds (ETFs) are certainly one of the best financial innovations to hit main street since mutual funds and retail online brokers. ETFs combine all the benefits of stock trading like instant execution, liquidity, and low fees with the diversification that mutual funds offer. It offers a great way to form a diverse portfolio through the use of passive investing. Additionally, there are now hundreds of different sectors, strategies, commodities, and asset classes to choose from. While these benefits are certainly great, retail investors need to also need to recognize some subtle risks that aren’t often widely publicized. Investors often start investing in a new ETF without fully understanding the actual objective or likely performance of the instrument in comparison to the desired benchmark. Here are four key pitfalls to watch for:
1. Leveraged ETFs are Terrible – I wanted to start with this one because the prospect of amplifying investment returns sounds just too appealing. If the long-term return on stocks is say, 9%, how great would it be to achieve 18% returns with a 2X leveraged ETF over a few decades? That certainly would be an incredible return given the power of compounding. The problem is, leveraged ETFs experience value decay over time. This is because of daily resets. As the underlying index fluctuates up and down daily, the leveraged returns gradually decline to the point that, if held over weeks or months, many of these ETFs will actually be negative while the underlying benchmark index is flat or positive. If you still don’t believe me, just take a look at a stock chart for virtually many leveraged ETF’s since launch and you’ll see it’s showing a substantial loss, regardless of what the index it was based on has done. You can even choose some volatile periods over the last year to compare a leveraged ETF with its underlying index. The findings are eye-opening.
2. ETNs are Different! – There are hundreds of exchange traded notes that look just like ETFs. They have a listed strategy, they represent a basket of stocks or commodities, they have an expense ratio, and people are excited about them. However, ETNs carry risks that ETFs don’t. ETNs are subject to solvency risk of the issuing company. Remember when investment banks were folding left and right during the financial collapse? Well, if you have an ETN issued by a firm that declares bankruptcy, when the dust settles, you’ll have to try your luck in bankruptcy court instead of redeeming shares at par value. So, in addition to tracking performance of the ETN, you’d also have to track the solvency risk of the issuing company. This is an additional headache and risk many buy-and-hold investors don’t want to take on.
3. Expenses Do Vary – While ETFs are often billed as low-cost investment vehicles, some of them do carry substantially higher fees than the best-in-class ETFs by Vangaurd, iShares, and other higher volume outfits. If you’re going to pay a 0.95% expense ratio instead of a 0.08% ratio, there’d better be a compelling reason why, or else you’re throwing money down the drain, especially over a period of many years. Many of the strategies employed by these ETFs sound alluring, but over time, they often perform no better than a simple benchmark index ETF.
4. Thinly Traded ETFs/ETNs – There are some ETFs and many ETNs that trade so few shares on a daily basis that the difference between the bid and the ask price is quite substantial. What this means is that if you enter a market order, you’re going to pay the “ask” price and when you eventually sell, you’ll get the “bid” price. This could cost you hundreds of dollars depending on the size of your order. On a highly traded ETF like the S&P500 (SPY), the bid/ask spread is always about 1 cent. Some of these thinly traded issues have spread of up to $1 per share. This dramatically increases the risk of the investment due to the lack of liquidity.
These warnings aren’t meant to deter you from investing in ETFs by any means. To the contrary, ETFs are great low-cost instruments when investors know what they’re buying and can stick to an investing strategy. It’s just important to understand in advance which types of ETFs and ETNs may not be right for you rather than finding out too late that you achieved a dramatically different outcome than you were anticipating.
What are your thoughts on ETFs and ETNs? What has your experience been investing in these financial instruments?