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How to avoid the pitfalls of exchange traded funds

Posted by admin on September 15, 2009 in Investment Products

I mused early this year whether exchange traded funds (ETFs) were contracting mutual-fund-itis: a product mangled by the excesses of the financial services industry.  It is not that either mutual funds or ETFs are, at their very core, inherently good or bad for the investor. It is that the execution of these products have evolved to favor the issuers and distributors (i.e. the advisor) to such an extent that it make little sense for the average investor to purchase most of the products on the market (and, yes, there are good mutual funds on the market but they tend not to be pushed to most retail investors).

For the ETF industry, we may have hit the tipping point of, to paraphrase the title of the 1990′s television show, when investment products attack! Both Jonathan Chevreau and Larry MacDonald have recently highlighted some of the larger issues of badly designed ETFs: leveraged ETFs not suited for most retail investors and ETFs developing larger than usual differences between their share price and net asset value (although the example MacDonald cites is due to regulatory issues). Finally, there is the usual issue of many competitors chasing the same dollars: excessive financial innovation leading to exoticism of product which may not suit many investors (my much cited ETF which tracks the airline industry-an industry that single-handedly keeps the bankruptcy lawyers employed-as example A).

Does this make ETFs scams, bad products, Madoff-esque in dealing with your money? No. As I indicated, the idea is fine. It is the execution which may be faulty.

Remember why anyone purchases ETFs:

1. Broad exposure and diversification;
2. Low fees; and
3. Easy ability to re-balance your portfolio.

Add to this list the investing maxim buy what you understand.

If the ETF you are considering purchasing does not fall within the above then take a pass. Otherwise you could end up with an ETF which tracks a very narrow index/industry/region with high fees relatively speaking or exotic ETFs that you don’t really understand (which most of the double, triple leveraged ETF’s are).

ETFs are following the evolution of most financial products (see hedge funds, mutual funds, corporate bonds issued by securitizations of receivables etc.): take a simple idea, begin selling product which mimics that idea closely, attract money, money attracts competitors, product begins to deviate from original idea, more money attracted, excess point reach with product now designed for issuers and distributors and not for investor. History has a way of repeating itself.

Thus, it is always important to think, for all investment products, why you are buying this product above and beyond making money.  If the product does not fall within why you should be buying the product, you may want to take a pass.