ETF investing pitfalls

Written by Alex

Topics: Investing

Pitfall! (photo: Dave Malkoff)

(photo: Dave Malkoff)

An Exchange Traded Fund (ETF) is similar to an index fund – they are typically not actively managed and therefore (often) have low management fees.  Sometimes when you can’t find the perfect fund for your asset allocation, an ETF will fill that gap.  But ETFs aren’t good for regular automatic investments, because you pay a trading fee each time you buy or sell, just like you would in a stock.  Also, they have other supposedly good features which are useless to regular investors:  you can sell them short, and you can trade them during the day (rather than only once per day with a fund).   Because of these features (and marketing), ETFs have gained popularity in the last couple years, and the flavors available have proliferated.

In watching your portfolio drop in the last year, if you are like most people you are wondering where you can invest your money so it’ll go UP, not DOWN.  Check out the finance.google.com page on most recent days, and you’ll see on the “Top Movers” list is the “ProShares Ultrashort Financials ETF”.  On 3/13 it gained 10% when the Dow was down 1.7%, and I’ve seen it gaining 30% or even 50% in a single day.  So you’re thinking, wow, I need to get a piece of THAT!  It’s a perfect hedge for your portfolio, since when the rest goes down, this goes up… right?

Not so fast.  This ETF is part of a certain class of ETFs which are very risky, volatile investments and shouldn’t be purchased by regular investors like you.  These ETFs have words in the name like: “ultrashort, double, triple, 2x, 3x, bear, bull”.  Something that is “2x”, for example, is designed to return 2x what regular investors would get in the underlying investment (e.g. a “2x S&P500″ ETF will gain 2x the S&P on up days, and lose 2X the S&P on down days.)  How do they do it?  All of these ETFs employ “leverage” to give the prescribed return profile, which means they borrow money so they can invest more.  It’s like investing on margin for regular investors – say you have $1000 to invest, but can borrow another $1000, allowing you to invest $2000.  So that when it goes up 10% to $2200, you give back the $1000, and made $200 or 20% (minus borrow cost) on an investment that only went up 10%.  On the flip side, if the investment goes down 10% to $1800, you still have to give back $1000 and now lost 20% (plus borrow cost) on an investment that only lost 10%. (Lesson: don’t invest on margin.)

Okay you say, but what if I use one of these as a small PART of my portfolio, as a hedge (like owning stocks and bonds together – one goes up, the other down)?  As Jason Zweig from the Wall Street Journal writes, this strategy can (will) backfire.  Due to the large swings in daily holdings values, leveraged ETFs are not designed as long-term investments.  They are for day traders, not investors.  For one example, on Friday the lovely ProShares UltraShort Financials had 31.92million shares traded – but it only has 6.8 million shares outstanding!  This implies an average hold time of 86 minutes.  The article quotes Andy O’Rourke, marketing chief of Direxion Funds, an ETF manager – holding a leveraged ETF longer than a day is “like using a toaster to cook a turkey.”

As usual in investing, you will be rewarded by sticking with the basics and not experiementing.  Reducing ‘oops’ moments will make you richer.

Have any thoughts on ETFs?  Please tell us about it in the comments.

2 Comments Comments For This Post I'd Love to Hear Yours!

  1. I have to admit, the picture made me laugh and recall fond memories of heavy blocked graphics. *grins*

  2. Alex says:

    I just got confirmation from a trader friend of mine saying they use the Ultrashort Financials and UltraShort Real Estate ETFs to macro-hedge their portfolios during the day. And even *he* calls the swings in prices of these crazy.

    -Alex

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