In your 40s? Avoid midlife-crisis investing

Don't be seduced too easily into buying ETFs, ETNs or other exotic investment products.

By TheStreet Staff May 16, 2011 11:00AM

Image: Throwing money down a hole (© Art Glazer/Stock Illustration/Getty Images)By Greg Plechner, TheStreet

 

We've seen the cliche, a 40-year-old hitting a midlife crisis and trading in his reliable 2002 Toyota Camry for a faster sports car that will likely get him into trouble -- at home and on the road. While we can all relate to being lured by owning the trendiest hot-ticket item, sometimes it's best to avoid those temptations, including when it comes to choosing retirement investments.

 

When you are in your 40s, you're well into what is often viewed as the "accumulation phase" of retirement planning, the period when you are usually working and contributing regularly to your 401k and other retirement accounts to build up your retirement nest egg. You may be advised to buy a diverse mix of mutual funds at companies with low cost structures and consumer-friendly business practices.

 

Which you do, of course, until a newer and sometimes more exotic product hits the market, with the promise of better and bigger returns. Recently, ETFs and ETNs have become those vehicles. Proponents point to their tax efficiency and low expenses, but they can also be more complex and potentially riskier. Before you trade in your staid mutual funds, take a closer look at what you are buying.

 

Exchange-traded funds

ETFs are securities that track an index, commodity or basket of assets much like an index mutual fund but trade like a stock on an exchange. Introduced in the United States in 1993, there are more than 900 ETFs in the U.S., with more than $800 billion in assets (as of September).

Although ETFs can be a great alternative to a mutual fund as a way to diversify one's portfolio, a risk is that, like stocks, they can be bought and sold in real time throughout a trading day. Therefore, unlike a mutual fund that generally is transacted at the end-of-its-day value, an ETF is subject to the whims of daily traders, some of whom could panic and drive down prices. The best example of this was the flash crash a year ago. When the Dow Jones Industrial Average fell by as much as 9.2%, investors panicked, resulting in some ETFs temporarily losing 50% or more of their value. Ouch!

 

While some investment professionals proclaim that one can often protect downside loss by placing a stop-loss order, this actually caused some investors to sell at the bottom of the artificial low created by the turmoil of the flash crash. With many of the sales now electronically programmed to transact upon certain conditions being met and lacking buyers, this can create a domino effect of unforeseen consequences.

 

Other types of ETFs carry even more risk, such as inverse or leveraged ETFs. Inverse ETFs seek to deliver the opposite of the performance of the index they track, while leveraged ETFs seek to achieve a return that is a multiple of the inverse performance. Again, one should proceed with caution, as these products can often fluctuate dramatically in price and carry additional risks because of their exposure to derivatives and other complex leveraged products that are also usually less regulated and more difficult to understand.

 

Exchange-traded notes

ETNs were introduced in 2006 and are structured products that, like ETFs and index mutual funds, are designed to provide an investor access to the returns of various market benchmarks. They are generally senior, unsecured, unsubordinated debt securities issued by an underwriting bank. Generally, when someone buys an ETN, the underwriting bank is promising to pay the amount reflected in that particular index (minus fees).

 

Like a stock or exchange-traded fund, an ETN is traded on an exchange and thus is subject to the same risks as discussed above. ETNs carry an additional and very important risk, though: the credit risk of the issuing bank. If there is a reduction in the bank's credit rating or, worse, if the underwriting bank goes bankrupt, the value of the ETN is threatened.

 

The best example of investors being burned by ETNs occurred in 2008, when Lehman Bros. filed for bankruptcy and its line of Opta ETNs was delisted from the stock exchange, likely resulting in people losing their entire investments.

As with your old Camry, sticking with a broad basket of traditional securities or index mutual funds as you accumulate retirement savings in your 40s -- rather than buying the latest ETF, ETN or other exotic investment product -- may not be the most exciting conversation starter, but the ride may be smoother and you just might reach your destination faster.

 

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