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ETFs: Five Reasons To Beware

Amy Buttell

13 May 2011

Exchange traded funds offer multiple advantages for wealth managers in managing client portfolios: they’re cheap, tax efficient and easy to trade. While ETF adoption lags far behind that of traditional mutual funds, wealth managers are on the leading edge of a trend that’s in the middle of its second decade.

Early on, ETF sponsors focused on what is still the market’s sweet spot: large, well-known, broadly-based stock and bond indexes. These include the always-popular SPDR S&P 500 (SPY), PowerShares QQQ (QQQ), iShares Russell 2000 Index (IWM) and the Vanguard MSCI Emerging Markets ETF (VWO).

Nipping on their heels are relative newcomers, which include leveraged and inverse ETFs, actively managed ETFs and extremely narrow, niche ETFs. These are gaining in popularity – alternative ETFs comprise half of the top 10 ETFs by trading volume as of early May, according to fund and ETF data-tracker Morningstar. But what’s popular is not necessarily sound investment selection and portfolio management for wealth managers, notes Richard Roche of Avatar Associates in Minneapolis, Minnesota.

Russell Wild, a financial planner in Allentown, Pennsylvania and author of Exchange Traded Funds for Dummies, agrees, saying, “There are now more than a thousand exchange traded funds available and I would say that many, if not most of them, have been introduced in the last two or three years and should only be used with lots of caution. They were created not out of necessity, but because ETFs are hot and the purveyor saw some potential in the market for them.”

So before putting ETFs in the mix for client portfolios, consider these five ETF investing pitfalls:

1. Leveraged, inverse ETFs stung by tracking errors. Leveraged and inverse ETF sponsors claim that these ETFs will deliver the opposite or two or three times the returns of the indexes they are based on. The problem is that those returns are on a daily basis, and over the long term, none of these products has come anywhere close to tracking its benchmark index, says Roche.

Worse still, the vast majority of them have lost money, even when their tracking indexes have risen, he adds. The risks are so great with leveraged and inverse ETFs that some firms have banned their advisors and investors from using them, including Edward Jones, LPL, Morgan Stanley Smith Barney, Ameriprise and UBS, he notes.

“Could there be for an advisor, or a sophisticated investor, applications in portfolios for leveraged and inverse ETFs down the road?” Roche asks. “Yes, there could be. But we at Avatar, as a third party manager of ETF portfolios for investors, are not comfortable with the huge tracking errors. When there are 52 ETFs that have been around for three years and they’ve all lost money, that’s a pretty big warning sign.”

2. High expense ratios cost more. One of the major attractions for wealth managers of ETFs is their rock-bottom expense ratios. But as ETFs have grown more complex and exotic, expense ratios have increased, Wild says.

According to fund and ETF data-tracker Morningstar, six ETFs actually have expense ratios over 1 per cent, with one, Dent Tactical ETF, weighing in at 1.50 per cent, and another, GS Connect S&P GSCI Enhanced Commodity Total Return ETN, at 1.25 percent. An astounding 151 ETFs and ETNs have expense ratios between 0.90 and 0.99 percent. Most of these are leveraged or inverse ETFs or ETNs.

“There are a number of newer ETFs that have very high expense ratios, in some cases higher than most mutual funds,” Wild says. Higher expenses cut into returns and undercut the case for owning ETF shares in the first place, he adds.

3. Exotic structures carry risk. Exchange traded notes (ETNs) may seem like another kind of ETF, but they carry far more risk, says Wild. “They sound similar but are very, very different,” he continues. “With an ETN, you’re taking credit risk that you’re not taking with an ETF or a mutual fund. An ETF is much more similar to a mutual fund than it is to an ETN.”

Rather than being based on a specific index like ETFs or mutual funds, ETNs are backed by a specific investment firm, so investors are “dependent upon getting their money back based on the credit worthiness of the issuer,” he says. In fact, some ETNs have gone bust, including several issued by Lehman Brothers that were not guaranteed by Barclays, which assumed some assets owned by Lehman.

ETNs are more tax efficient than many ETFs, but the trade off may not be worth the risk, Wild says. “If you’re going to speculate in currency futures or commodities, it’s a more tax-efficient way of doing it than using an ETF, but I wouldn’t recommend it,” he adds.

4. Intraday trading options potentially hazardous. Few wealth managers can forget the “Flash Crash” of 6 May 2010, when the market for certain securities dropped like a rock. Much of that turmoil was traced back to ETF trading, Roche says, and some advisors who constructed their own ETF portfolios got hammered when the market fell and their limit orders were executed far below their stop-loss order.

And because of the way the stock exchanges handled losses from the Flash Crash, many investors who lost some, but not all of their money weren’t compensated, he says. In fact, a report by the Securities and Exchange Commission and the Commodities Future Trading Commission noted that 69.6 percent of the trades that were broken on the day of the Flash Crash involved exchanged traded funds.

5. Actively-managed ETFs untested. Actively managed ETFs are the most recent newcomers. Few have the track records necessary to gain ratings by data trackers such as Morningstar and Lipper. In the absence of those track records, it’s hard to justify investing there, says Wild. Also, ETF sponsors tend to charge more for active ETFs, which makes the case even less compelling versus traditional mutual funds, Wild adds.