The Big ETF Warning

ETFs Can Make for a Dangerous Investment Tool

Peter Leeds with Money Pig
Pig in Chair Surrounded by Coins. Michael Paras, Paper Boat Creative

You have probably heard about ETFs (Exchange Traded Funds). In fact, you may have already traded them on a few occasions, or possibly hold a few right now.

For those who aren't familiar with ETFs, I'll give you a quick summary to get you up to speed. However, whether you are an experienced investor or brand new to the game, you must hear the warning I provide about ETFs, because they can cost you.

This issue already has hurt your investment dollars, if you ever have or currently own exchange traded funds.

In the event that you have ever bought any double or triple leveraged ETFs, and held them for more than a couple days, then you will definitely want to keep reading.

Explained simply, exchange traded funds (ETFs) are investment products which are actively managed to attempt to mirror the trading activity of an index, or an industry, or country's stock market. For example, the ETF which goes by the ticker symbol "DIA" is made up of the stocks of the Dow Jones Industrial Average, and as the DJIA rises, so too should the DIA investment vehicle.

There are also ETFs which track oil (USO), consumer discretionary stocks (XLY), financial stocks (XLF), the Nikkei (Japan - EWJ), NASDAQ (QQQ), and plenty of other industries, indexes, and foreign stock exchanges. There is even one which tries to follow the Fear Index (known as the VIX), using the ticker symbol VXX.  Since the Fear Index (or market volatility index) can not be traded on it's own, the VXX makes a great way to get involved.

The beauty is that exchange traded fund are just like stocks. You can buy an ETF which tracks the German stock exchange, then turn around and sell it within minutes if you change your mind.

So you want more foreign exposure to developing nations? You could buy a few ETFs like DBEF, EIRL, EDEN, and CBON, and instantly have holdings in Germany, Ireland, Denmark, and China.

Changed your mind once you bought? You can adjust your holdings as simply as buying and selling shares of any publicly-traded stock.

Here's the rub. The intention of ETFs is to track or mimic the performance of the underlying investment. The phrases "track" or "mimic" are especially important. Notice I did not say "duplicate", "outperform," or "match."

By their nature, on a perfect day, an ETF will at best match the performance of the index or stocks which it is designed to follow. If you own USO, and West Texas Intermediate oil prices rise 4 percent, the ETF will increase 4 percent at best.  More likely, it will rise 3.9 percent or so, to make up for the management expenses and "slippage" which is the big part of my warning to you which I explain in this article.

While standard ETFs are usually pretty good in terms of mirroring the underlying investments they are attempting to track, there is a slight drop-off in returns. You will get hit with the "MER," which is the management expense ratio, which is not unlike what you're already paying on mutual funds or any actively managed investment products.

The MER is a slight payment which goes to the ETF's managers. You probably will not even notice how that money is being quietly pulled out of the ETF's returns, because it is a very small amount, and comes out automatically and without fanfare.

The management expense ratio for ETFs is actually lower than that of mutual funds, and you will get a more "true" reflection of the investment you meant to buy. ETFs are good at sticking to the rules of what they are intended to track - a product like GLD is meant to follow gold prices, and that is what it does.

On the other hand, a mutual fund meant to focus on the yellow metal may own companies which mine silver and gold and copper or have continuously changing cash positions, for example. So much of what a mutual fund holds in their portfolio is based on the decisions of that fund's manager.

This all results in mutual funds having greater management costs than ETFs. However, there is still a dark side to exchange traded funds.

Before you buy another exchange traded fund, you need to understand the harsh impact of slippage.

In fact, once you understand the manner in which these investment vehicles perform, you may even decide to avoid them altogether.  You will certainly want to stay away from the double and triple leveraged ones completely.

As mentioned, ETFs which are "straight up," meaning that they are designed to follow an underlying index or market or commodity exactly, are typically less prone to the greatest impact of slippage, although this will still be a consideration.

It is the "levered" ETFs which could send you to the poor house pretty quickly. Many specialized exchange traded funds are designed to produce double or triple the moves in the underlying investments.

For example, UWTI attempts to provide three times the moves in the underlying price of west texas intermediate oil. If WTI goes up or down 5 percent, UWTI is meant to produce gains or losses of 15 percent.

The massive problem, as I alluded to, is slippage.  Let's use our same UWTI example, but these concerns apply to all leveraged ETFs.

When oil rises 10 percent on a single day, UWTI might not rise 30 percent. Rather, it may show gains of 28 or 29 or even 29.5 percent for the day.

When oil drops 10 percent the next day, UWTI may slide 30 percent lower, acting exactly how it was intended. Conversely, it may also drop 30.5 percent or 31 percent.

The tiny, barely noticeable fractions of a percent happen each day as the managers balance their books. Over time, these negligible amounts add up.

Let me ask you - how many days would it take for half-of-one-percent slippage to impact an investment?  Remember, this gets applied every day, so the longer the time frame, the greater you funds which have "slipped" away.

If silver prices rose 1%, then fell 1% the next day, the underlying commodity would not have changed in value.  However, the triple-leveraged ETF which tracks silver prices (USLV) will have lost a slight portion of its value.

This is why a long-term chart of any triple leveraged ETF will show a consistent downtrend over the months and years. They all eventually cost their long-term investors 100% of their money.

Said another way, leveraged ETFs are destined to shrink in value every day, compared to the activity of the assets, commodities, stock exchanges, or indexes which they attempt to mimic. This does not make for a wise medium term or long term investment approach.

No triple leveraged ETF is appropriate to hold for the long term. Even standard ETFs are best suited for short term and day trading purposes.

ETFs make a great way to diversify your holdings, and to hedge your portfolio. For example, if you have too much exposure to American-based companies, you can quickly and easily buy an ETF which focuses on businesses from Denmark, or Brazil, or South Korea.

Just don't plan on leaving your money invested like that for years at a time. In that case, you may be better served by buying the individual stocks which make up the ETF itself, which can be publicly viewed in most ETF's online summary.