Why people fail investing in ETFs

Posted by on March 24, 2010 in Investment Information

The lines between mutual funds and exchange traded funds (ETFs) have blurred over the last few years. Whereas ETFs used to be the vehicle to track broad based indexes, the flood of niche and specialty ETFs have some investors now using the same analytical approach to picking ETFs as mutual funds. Mainly, investors are buying on name, resulting in the same type of asset misallocation and product redundancy found in investing in mutual funds.

Part of the issue comes down to how ETFs are constructed. Most ETFs track a particular index. What happens if an ETF issuer wants to exploit the popularity of a new and growing niche? Why, someone has to create an index. This has spawned new growth opportunities for index creators.

The issue is that many of these indexes are created with over-laps with other indexes. For example, the Dow Jones Emerging Market Stock Index, used as an index for emerging market ETFs, has a country allocation of almost 65% in the BRIC countries (Brazil, Russia, India and China) as of February 2010. Add a China or India ETF in addition to an ETF tracking this index and one’s asset allocation may now be overweight in two countries with stock markets not known for their stability (there is a reason why most wealthy Mainland Chinese attempt to export their money to other jurisdictions; the government still has broad discretion to seize “private” property and the stock market has a dubious reputation).

The second issue is that some ETF issuers attempt to slice an already targeted index into even thinner wedges. For example, PowerShares QQQQ tracks the largest 100 non-financial stocks on the NASDAQ.  This sounds great in light of the uncertainty surrounding the financial sector. The issue is that NASDAQ is a tech heavy exchange which, as ETF experts have pointed out, create a sector specific reliance not suitable to most long-term investors and pushes an investor into a large risk/reward position if combined with a broad based tech ETF or NASDAQ ETF.

Mutual fund or ETF, the problem is essentially the same. Buffet style investing, picking a little of everything, and buying on name power leads to a portfolio with redundancies, non-ideal asset allocation (usually towards greater equity weighting) and unnecessary payment of fees on product one may already substantially hold. To be Clinton-esque about it, it’s not the product stupid, it’s the strategy.

An analysis that buying ETFs is good is simplistic. Wall Street has figured out how to exploit such simplicity. Buying ETFs may save an investor money in fees but if the product should not have bought in the first place, is that really money saved? If in doubt, buy ETFs tracking broad based indexes and forget the fancy stuff.

(As a side note, it is interesting to note that many of the newer index creators are actually mutual fund issuers. For example, Claymore issues several ETFs which track indexes created by MFC (e.g. MFC Global Agricultural Index). If you work your way through the prospectus, MFC is a trademark of MFC Global Investment Management, owned by mutual fund issuer Elliot & Page Limited which, in turn, is owned by Manulife Financial- the insurance and mutual fund giant. The financial industry has a myriad of ways to part you with your money.)

6 Comments on Why people fail investing in ETFs

By 2 Cents @ Balance Junkie on March 24, 2010 at 8:45 pm

I guess it was only a matter of time, wasn’t it? How long will it be until ETF expense ratios rise as well?

By Vasile on March 25, 2010 at 12:08 pm

When referring to NASAQ, I think you misspelled NASDAQ? Or I’m just missing something?

By admin on March 25, 2010 at 1:00 pm

Thanks. It has been fixed.

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