ETFs: The Bloom is Off

Two years ago, exchange traded funds were like the hot, new car model for which buyers would pay a $3,000 premium over list price, all for the privilege of being waited listed for months before the gotta-have-it vehicle was delivered. Asset management firms charged into the fray, registering hundreds of new ETFs based on all varieties of indexes, including some never before seen in the wild, and threw them at investors to see what would stick.

That was 2007. We know what's happened to the financial markets since then. A turbulent market reveals a multitude of sins, defects and other undesirable features, and no exception was made for ETFs. Here are some of the problems that have emerged.

High Trading Costs. Although ETFs often have comparatively low management fees, the costs of investing also include the "bid-ask spread," which is the difference between the higher ask price at which you buy ETF shares and the lower bid price at which you sell them. Management fees, on average, have been rising as ETFs have become more complex, now often exceeding 0.5% of assets per year. But, for the smaller, less liquid ETFs, trading costs can add an additional 1% to the costs of ownership. This trading cost isn't an annual charge. But it is effectively imposed each time you make a round trip in trades (i.e., buy and sell). Since many investors trade ETFs on a short term basis (a bad idea more often than not), these trading costs can become a major expense.

ETF Value Strays from Underlying Values. Sometimes, the value of the shares of an ETF can deviate from the value of the underlying holdings. The reasons for this vary. Sometimes, the index on which the ETF is based contains illiquid investments (like some bonds) that the ETF has trouble actually buying. In such cases, you're not getting what you probably thought you were getting. Other times, the ETF trades at a premium because investor demand elevates the ETF share price. For example, a relatively easy way to participate in the recent rally in corporate bonds is to buy shares of a bond ETF based on a corporate bond index. But that advantage can be reduced if everyone else has the same idea and bids the price of the ETF above underlying asset values. It's usually not a great idea to pay $1.02 for $1.00.

Leveraged ETFs give an unpleasant surprise. Leveraged ETFs promise to give you a multiple of the price movement of the underlying index. In other words, if the underlying index increases by x, the leveraged ETF is supposed to deliver a return of 2x. If the the underlying index drops by x, the leveraged ETF would show a loss of 2x. Short or inverse ETFs deliver the leveraged opposite of the movement of the underlying index. Some leveraged indexes have sustained significant losses even though the underlying indexes have, over time, gone in a direction that would appear profitable. For example, an underlying index might rise, but the leverage ETF sustains losses. Perhaps the most common reason for this deviation is that leveraged ETFs calculate gains and losses on a daily basis. Even if the underlying index rises over the course of several months, the daily ups and downs can create a compounding effect that generates net losses where a casual observer or investor would have expected gains. Moral of the story: stay away from leveraged ETFs. These things are for full-time investment professionals who are used to walking on hot coals with their bare feet.

The early version ETFs, based on well-known broadly based indexes, continue to be useful and valuable investments in many circumstances. See http://blogger.uncleleosden.com/2007/06/exchange-traded-funds-for-beginners.html. But the fancier and faster-talking the ETF, the more you should put your hand on your wallet.