The bad boys of the ETF world

Welcome to the investing mainstream, ETFs. You've got buzz, you've got momentum and now you've got issues.

Exchange-traded funds are the smaller but faster-growing rival to mutual funds. This week, they received a unique endorsement when one of the country's biggest fund companies, Invesco Trimark, introduced a lineup of eight funds that are basically a vehicle that investment advisers can use to put ETFs in client portfolios (read more here: tgam.ca/DnR).

Whether you're a do-it-yourself investor or have an adviser, ETFs are a versatile, sensible tool for portfolio building. But complaints about them are mounting, even as the global ETF industry prepares to supplement the existing 1,820 or so existing funds with another 811 new products. In this edition of the Portfolio Strategy column, we look at the dark side of ETFs by discussing four cases where buyers should beware.

1.) ETFs that track the price of a single commodity

These ETFs invest in futures contracts, which are essentially bets on what the price of a commodity like oil or natural gas will be at a future date. The problem is that futures contracts sometimes do a poor job of tracking the spot price of a commodity, which is the price in the here and now and the one most people pay attention to.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:d0fa4e14-88d2-41f9-8a19-896bdff9544b

The issues associated with futures contracts have been exacerbated by huge investor demand for single-commodity ETFs. A good example is the United States Natural Gas Fund, which grew to $4-billion (U.S.) at midyear from $300-billion last December. This ETF was such a dominant player in the natural gas futures markets that regulators temporarily blocked it from issuing new units to satisfy investor demand.

"Generally people buy a fund called United States Natural Gas because they think they're tracking natural gas prices," said Paul Justice, ETF strategist at Morningstar Inc. in Chicago. "They are not. They're using futures contrasts, which are generally - but not always - a good proxy for what gas prices are doing."

USNG's year-to-date loss as of late this week was about 61 per cent, which compares to a decline of almost 38 per cent for the spot price of natural gas.

Mr. Justice's suggestion to retail investors about single-commodity ETFs: "Use them sparingly, if at all." As a replacement, consider commodity-basket ETFs, which may have exposure to a dozen or more commodities.

2.) ETFs with few holdings

One of the benefits of investing in stock and bond indexes through an ETF is that you get wide diversification through a single purchase. An index may include dozens, hundreds or even thousands of stocks, but not always. A good example is the S&P/TSX capped information technology index, which you can invest in through the iShares CDN Tech Sector Index Fund. There are five stocks in the index: CGI Group, Research In Motion, Open Text, Celestica and MacDonald Dettwiler and Associates.

At the portfolio management firm PUR Investing, they figure that it's worth buying the iShares CDN Tech Sector Index Fund only if you plan to invest $13,000 or less. Here's the math: At $18 per stock-trading commission, you'd pay $90 to buy the five stocks in the S&P/TSX tech index. With the ETF, you'd pay $18 to buy and ongoing fees of 0.55 per cent, which amounts to just about $90.

"For investors looking to invest more than $13,000 in [the iShares fund] they are better off owning the five stocks," PUR president Mark Yamada said in an e-mail.

A similar ETF is the new BMO S&P/TSX Equal Weight Banks Index ETF, which holds the shares of the Big Six banks in equal proportions. The management expense ratio here is also 0.55 per cent, which raises another issue about ETFs with few holdings. Shouldn't their fees be minimal, just like the number of holdings?

3.) Marginal ETFs

It's worth noting that while 295 ETFs were launched globally in the first nine months of this year, 72 were shut down. The story here is that ETF companies are trying to sustain their growth momentum by issuing products investors are rejecting because they are superfluous or poorly conceived.

Be on the lookout particularly for ETFs based on indexes that are not recognized benchmarks, but rather contrivances designed only to support the ETF. The PUR Investing people say they look for indexes with at least five years of actual index performance (not backtesting data, which is invariably glowing and thus unreliable).

"We would go for more transparent indices that represent an asset class well, not a novelty like the Wal-Mart suppliers ETF," Ioulia Tretiakova of PUR said in reference to the now defunct FocusShares ISE-Revere Wal-Mart Supplier Index Fund. It was based on the ISE-RevereWal-Mart Supplier Index of companies that derived a substantial portion of revenue from Wal-Mart. Looks like no one else but FocusShares and ISE Revere thought that was a good idea.

Another example of ETF companies straining for uniqueness with their products is the PowerShares NXQ Portfolio, which tracks the 50 stocks next in line to be included in the Nasdaq 100 index. ETFs were built on the idea of providing a way to invest in companies that are included in benchmark indexes. This ETF focuses on companies that haven't made the cut.

Other examples of marginal ETFs: the HealthShares Dermatology and Wound Care, Autoimmune-Inflammation and GI/Gender Health ETFs, all shut down a year ago along with a dozen similar funds.

4.) Leveraged ETFs

Morningstar's Mr. Justice helped spur a backlash against these popular ETFs in January when he issued a report with the headline "Warning: Leveraged and Inverse ETFs Kill Portfolios." Though these ETFs routinely rank among the most actively traded stocks in Toronto and New York, they're best avoided by the average retail investor.

Leveraged ETFs come in bull and bear versions and are designed to give you two (or, in the U.S. market, three) times the daily up or down move in a particular stock index, commodity, bond or currency.

"That only applies over the course of a single day," Mr. Justice stressed. "Over longer terms, returns can vary widely."

In fact, there have been cases where investors have guessed the right direction for a stock index or commodity, bought the appropriate bull or bear leveraged ETF and still lost money. Mr. Justice says that the more volatile the underlying investment for a leveraged ETF, the higher the risk of losing money.

Some U.S. investment firms have taken leveraged ETFs off the menu of products their advisers can sell, he noted. "It boils down to suitability. Most people have long-term investment goals and these products are not really designed to help people meet those goals."

Buyer Beware

Here are four kinds of exchange-traded funds that retail investors should be careful about buying: