by Tyler Curtis
Although exchange traded funds (ETFs) provide an effective and easy way to gain exposure to different asset classes or sectors, not all of them are the same. ETFs that are created to track the same sector, related indexes, and even the same index will vary in performance because of a variety of different factors. As ETFs gain even more popularity and as more varieties such as actively managed ETFs come onto the scene, it is becoming increasingly more important to recognize the differences between these funds.
Currently representing around $1.7 trillion in assets, the global ETF market is massive. In just a short period of time ETFs have grown from just tracking major indexes to now covering hundreds of different sectors, strategies, commodities, and asset classes. While these benefits are great, it is important for retail investors to recognize some of the subtle risks that aren’t often publicized. Investors often start out in new ETFs without fully grasping the actual objective or likely performance of the fund in comparison to its desired benchmark. There are a few key pitfalls of ETFs that investors should watch out for.
The most commonly misunderstood ETFs are Leveraged ETFs. Leveraged ETFs are typically created in an attempt to capture two to three times the daily move of an index. The prospect of amplifying investment returns by 2 or 3 can sound quite appealing. If the long-term return on stocks is say 10%, how great would it be to achieve 18% returns with a 2X leveraged ETF? The problem is, leveraged ETFs experience value decay over time. This is because of daily resets. As the underlying index fluctuates over time, the leveraged long term returns gradually decline to the point that if held over weeks or months, many of these ETFs returns will be negative while the underlying benchmark index is flat or positive. Try comparing virtually any leveraged ETF to the index it is tracking over a longer period of time, the findings are eye-opening.
Even though most ETF expenses are much lower than similar mutual funds, expense ratios for substantially similar ETFs can vary greatly. Some ETFs carry larger fees than the best-in-class ETFs by Vanguard, iShares, and other higher volume outfits. If you are going to be paying a 0.50% expense ratio instead of a 0.08% ratio there had better be a compelling reason why, or else you are simply throwing money down the drain in the form of excess fees.
Thinly traded ETFs can also cost investors by execution. There are some ETFs that trade so few shares on a daily basis that the difference between the bid and ask price can be quite substantial. This can cause investors to over pay for an ETF when a substantially similar ETF with higher liquidity could have been purchased instead. This issue is even more amplified when trading options on thinly traded ETF instruments.
These warnings are not meant to dissuade you from investing in ETFs by any means. Here at Snider Advisors we feel that ETFs can be great low-cost instruments when investors understand what they are purchasing and can stick to an investing strategy.
Click here to learn more about our Snider Method ETF Portfolio.