5/5/2014 12:45 PM ET|
4 ways to stay out of ETF trouble
Exchange-traded funds have many benefits, but you should look out for low-liquidity and leveraged ETFs.
Exchange-traded funds are open-ended funds that can be bought and sold on a stock exchange. You can think of them as a hybrid version of both stocks and index funds. You buy them using a broker, just like you would to purchase a stock. They consist of a portfolio of securities that are designed to track different indexes, just like index funds.
The first ETF was launched in 1993, and since then they have become very popular with investors. According to BlackRock's December 2013 industry highlights data, the ETF industry has captured $2.4 trillion in assets since 1993. There are almost 5,000 ETFs available.
Used appropriately, ETFs can permit you to assemble a globally diversified portfolio of stocks and bonds, in a suitable asset allocation, at a low cost. Unfortunately, ETFs can be a trap for the unwary. Here are some tips to avoid potential pitfalls.
Avoid high-fee ETFs
A high-cost ETF should be an oxymoron. A primary benefit of buying ETFs is the ability to track an index at a low cost. Unless the ETF you are buying has a lower expense ratio (management fee) than a comparable low-cost index fund, you should consider purchasing the index fund instead.
Just because an investment is designated as an ETF doesn't mean it's low-cost. There are a number of ETFs that have expense ratios in excess of 1 percent. A few have expense ratios that exceed 2 percent. At the other end of the spectrum, ETFs are available with expense ratios as low as 0.04 percent.
When comparing ETFs that track the same index, with all else being equal, you should purchase the lowest-cost ETF available.
Avoid low-liquidity ETFs
Liquidity is an important consideration to make when selecting an ETF. An ETF that is highly liquid will have lower trading costs and be easier to buy and sell than an ETF that is less liquid.
The liquidity of an ETF is affected by many factors. These include the trading volume of the securities that make up the ETF, the composition of the ETF and the trading volume of the ETF itself.
ETFs that invest in large-cap stocks in developed economies, or track broad indexes, are the most liquid, writes William Artzberger, a CFA based in Houston, on Investopedia. For fixed income, ETFs in which the underlying bonds are Treasury bonds or corporate-grade bonds are more liquid than ETFs that hold riskier bonds.
Avoid leveraged and inverse ETFs
The securities industry is incredibly adept at creating new products that encourage trading. Leveraged and inverse ETFs are examples of products that were created to be sold and not bought.
A leveraged ETF seeks to amplify the returns of an underlying index, using financial derivatives. For example, a leveraged ETF that tracks the Nasdaq-100 index might have a 2-to-1 or even a 3-to-1 ratio, and would be structured to return twice or three times the returns of the underlying index. Of course, if the underlying index drops in value, your losses would be increased by twice or three times the losses in the index.
An inverse ETF is structured to benefit from a decline in the value of the underlying index. Depending on the structure of the inverse ETF, investors can earn double or triple the percent of losses in the underlying index.
There are many problems with leveraged and inverse ETFs. The most obvious is they are highly risky investments. Investing in these funds is pure speculation, rather than responsible, long-term investing.
There is also concern about whether or not these funds perform as advertised. A survey of leveraged and inverse ETFs, which was released in the spring 2012 edition of The Journal of Index Investing and authored by Gerasimos Rompotis, concluded that over longer periods of time (more than one day), returns of these funds may not perform as advertised.
Finally, the management fees charged by leveraged and inverse ETFs are among the highest of those levied by all ETFs. For example, a leveraged commodities fund issued by VelocityShares has an expense ratio of 1.65 percent.
Avoid trading ETFs
One of the oft-stated benefits of ETFs is that they trade on an exchange and you can easily buy and sell them, just like stocks. However, John Bogle, founder of the Vanguard group, says this ability to trade is both a blessing and a curse.
The wide array of available ETFs encourages bad investor behavior, like trying to select outperforming asset classes and engaging in in-and-out trading. Bogle believes investing in ETFs should be limited to funds that track broad stock and bond indexes.
Follow that advice, and you won't get ripped off by the allure of ETFs.
More from U.S. News & World Report
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I would like to see a study on how ETF's track against identical bench marks.
Be it the DOW, NASDQ 100, SP 500, etc., against mutual funds that have the same components.
The only difference should be expense ratios, but I doubt that they work that way.
Also, do the ETF's resync with the benchmarks after the markets close?
I would also be interested in knowing if ETF's are heavily traded by high frequency traders.
It would be interesting to see both short term and long term results, that includes expense ratios. .
When do you need a wake-up call? Typically when you are a sleep. Right?
Now, John Kerry said "the Russian / Ukrainian situation was a "WAKE-UP call". Gee, how honest and rarely soon was John Kerry, he admitted he, Obama and the Democrat Party have been ASLEEP regarding Russia!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! All the while laughing at those who, unlike themselves, did not have their heads up their AZZes. Rommney, said Russia was a geo political threat. Obama laughed. And, not a fan of Palin, but Palin said Putin was eyeing Ukraine.
So do you Democrat morons still need a wake-up call? Kerry was honest enough to admit he an Obama had been a sleep. So should you now be awake enough to know you can not trust a Democrat regarding foreign policy? how many times must Obama be such a fool? Red line, erase red line, redraw red line, pretend it was not crossed, threaten Putin, do nothing, rattle a saber over Iran, do nothing..... and then have teh world laugh at you and run circles around you.
this is not a game either. China may very well see this fool in the white house and attack Tiawan. You laugh, well why the helll should then not? Because Obama draws another line?
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