ETFs: Separating the Good from the Bad

Exchange-traded funds aren't a small, vanilla lot anymore

In my last article, I discussed exchange-traded funds, their pros and cons, and the most important characteristics that investors need to know before choosing from the 1,400-plus ETFs now on the market.

Many investors frequently make the mistake of chasing returns and blindly select ETFs that have the highest short-term gains. That’s a big mistake!

Ride the Slow Boat That’s China
Ride the Slow Boat That’s China

Unfortunately, the ETF world has caught up with the equity marketplace, with investors abandoning a long-term outlook and instead jumping on the next “hot” idea. This has led to the proliferation of a variety of ETFs, many that are thirstily sucking up investors’ hard-earned money. But on the bright side, innovation in the ETF space also means investors now have a broad choice of different ETFs to select from.

The key is — as with any investment — separating the good from the bad.

Let’s first take a look at the different types of ETFs available to you today, beginning with those that are weighted by alternative parameters:

  • Market-cap weighted. These are the original ETFs, which give more weight to the largest companies in terms of market capitalization. During a bull market in large-cap stocks, these ETFs can pay off very well for investors. But as the market turns toward small- and mid-cap stocks, the overvaluation of the large-cap stocks in these ETFs (from the run-up) can turn the tables and cause these ETFs to flounder.
  • Equal-weighted. These ETFs weigh each stock in the index exactly the same. They tend to do better when small-caps are hot, generally following an economic downturn, in the early stages of a recovery.

Then, there are a host of fundamentally weighted ETFs, sometimes called “intelligent” or “smart” ETFs, which weigh companies by fundamental measures such as company size, sales, profits, dividends, growth and value. These include:

  • Revenue-weighted. These ETFs are based on the sales, or top-line growth of a company. These ETFs will give less weight to stocks with a high price-to-revenue multiple and more weight to stocks with a low price-to-revenue multiple. In other words, companies that are undervalued, relative to their revenue growth, will be given a higher weight in the index.
  • Earnings-weighted. These ETFs focus on companies that have high profit margins. By including only companies with income, these ETFs tend to be a bit less volatile, as their indices are made up mostly of value-oriented businesses. That means they tend to do better in down markets and not as well in a market in a bullish trend.
  • Dividend-weighted. These ETFs include stocks that pay cash dividends. Consequently, these ETFs also generally are more value-oriented. However, a dividend-weighted ETF does not necessarily correlate with high yields, as the weighting is applied by the total amount of cash dividends and not yield. As well, investors should be aware that these ETFs often include companies with lower margins, not in a high-growth mode.

Investors should note that fundamentally weighted ETFs often carry higher fees than market-cap or equally weighted ETFs, since, allegedly, these ETFs require more manpower and man hours to manage.

There are just a few more categories of ETFs that I want to talk to you about today — ETFs that should mostly be avoided by the average investor:

  • Factor ETFs. These are sort of “hedge-fund” mimics and include ETFs that make mega-bets, according to investment style, momentum, volatility or beta. Targeted toward institutions that regularly invest in hedge funds, these ETFs are in a growth mode. As you might expect, these ETFs can give investors exposure to stocks that are more or less volatile than the broader markets. Higher-beta stocks come with more risk, and vice-versa, and they also tend to be expensive relative to other ETFs.
  • Non-U.S. debt ETFs. These are primarily for emerging economies, whose missions are big growth and large interest payments. As you might imagine, high returns are possible, but so is high risk as these ETFs play in foreign currencies backed by governments other than the U.S.
  • Alternative tool ETFs. These are ETFs set out to mitigate portfolio risk. They include merger-arbitrage funds, but tend to be expensive and also can consist of just a few instruments within the fund — a lack of diversification that can negate their risk-reduction objective.
  • Leveraged ETFs. These use derivatives and seek to magnify broad index returns — either on the long or short side — and usually target 2x or 3x market returns. For example, an ETF with a 2:1 ratio would theoretically result in twice the market return. If the underlying index declines 1%, your loss would be 2%, and vice-versa. But be aware that high management fees will cut into your returns. But much worse is a larger concern that most investors don’t know about: Returns for leveraged ETFs are predicated on a daily, not annual, basis, so they are subject to very volatile, daily fluctuations, meaning your returns might not approach that 2x or 3x stated return at all! Instead, you might find yourself losing much more than two or three times market losses. These ETFs are only for the most sophisticated risk-takers and should not be part of the average investor’s portfolio.
  • Actively managed ETFs. These, rather than index-tracking ETFs, are gaining popularity with money managers who are switching their allegiances from mutual funds to ETFs. But beware that “active” means more turnover and more fees, as well as not-so-good performance in the long term, as proven in actively managed mutual funds.
  • Commodity ETFs. These can be purchasers of futures contracts or the underlying assets. Investors generally will find the commodity ETFs that hold the assets a better bet, as they avoid some of the problems of the futures ETFs, including failing to track their target indices, contango and backwardation — both relating to spot vs. forward prices, which can get unsophisticated investors caught in a costly fix.

As you can see, ETFs are no longer vanilla, market-weighted funds based on broad indices. Consequently, it’s investor beware.

I’m not suggesting that you should only buy the basic, market-weighted ETFs. In fact, I like a lot of the fundamentally weighted ETFs and think investors should hold a variety of these, based on your own investing strategy and goals. An investor who doesn’t have a lot of time to dedicate to his portfolio easily can create a diversified portfolio of profitable ETFs — for the long term.

But please make sure you read the fine print. Go beyond returns and examine the ETF, just like you would any other investment. And if you are not a very experienced, sophisticated market maven, some of the esoteric, more complicated ETFs should be avoided at all costs. Why risk your hard-earned money for something that is difficult to understand and fraught with major downsides?

You still can achieve market-beating returns if you select well, diversify and pay a bit of attention to market cycles so you can structure your portfolio to take advantage of the best ETFs during downturns and bull runs.

Next up: 5 ETFs to Buy for Growth in 2012

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