Excessive risks and costs with leverage: Some ETF issuers have come out with riskier and more costly ETFs. One particular class of ETFs I especially dislike is so-called leveraged ETFs. What these ETFs purport to do is magnify the move of a particular index — for example, the Standard & Poor’s 500 stock index — by double or triple. So a double-leveraged S&P 500 ETF is supposed to increase by 10 percent for every 5 percent increase in the S&P 500 index. Inverse leveraged ETFs are supposed to move in the opposite direction of a given index. So, for example, a double-leveraged inverse S&P 500 ETF is supposed to increase by 10 percent for every 5 percent decrease in the S&P 500 index.My investigations of whether the leveraged ETFs actually deliver on their objectives show that they don’t, not even close. For example, in the two-year period ending in early 2010, one double-inverse S&P 500 ETF (brought to my attention by a reader who owned it and asked me about it) fell by 43 percent, a period during which one would have expected to have increased about 28 percent because the S&P 500 index actually fell by 14 percent.
TABLE 5-1 The Companies of the Standard & Poor’s 500 Index at the End of 1999
| Stock | Rank in Index | Market Value | Percent of Index |
|---|---|---|---|
| Microsoft Corp | 1 | $604,078 | 4.92% |
| General Electric | 2 | $507,734 | 4.14% |
| Cisco Systems | 3 | $366,481 | 2.99% |
| Walmart Stores | 4 | $307,843 | 2.51% |
| Exxon Mobil | 5 | $278,218 | 2.27% |
| Intel Corp | 6 | $274,998 | 2.24% |
| Lucent Technologies | 7 | $234,982 | 1.91% |
| IBM | 8 | $194,447 | 1.58% |
| Citigroup Inc. | 9 | $187,734 | 1.53% |
| America Online | 10 | $169,606 | 1.38% |
Seeing the pros and cons of trading ETFs
One supposed advantage of trading ETFs is that, unlike the regular index mutual funds I recommend in this book, you can trade (buy or sell) ETFs throughout the weekdays when the stock market is open. When you buy or sell an index mutual fund, your transaction occurs at the closing price on the day that you place the trade (if the trade is placed before the market closes).
Timing your moves in and out of the stocks: Being able to trade in and out of an ETF during the trading day isn’t a necessity, nor is it even a good practice. In my experience of working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day. In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that’s far easier said than done.
Paying a brokerage commission every time you buy or sell shares: With no-load index funds, you generally don’t pay fees to buy and sell. But with ETFs, because you’re actually placing a trade on a stock exchange, you pay a brokerage commission every time you trade through some brokers. For example, if you buy an ETF with a seemingly low expense ratio of 0.1 percent and you pay $10 to trade the ETF through an online broker, that’s equal to paying two years’ worth of management fees if you invest $5,000 in the ETF!
Figuring out whether the current price on an ETF is above or below the actual value of the securities it holds: Because ETFs fluctuate in price based on supply and demand, when placing a trade during the trading day, you may face the uncertainty and complication of trying to determine (if you care) whether the current price on an ETF is above or below the actual value of the securities it holds. With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds.
Identifying the best ETFs
The vast majority of investors don’t need to complicate their lives by investing in ETFs. Use them if you’re a more advanced investor who understands index funds and you have found an ETF that’s superior to an index fund you’re interested in or use a highly suitable and well-established ETF as a long term core position. But do not use ETFs to make short term bets, which is a fool’s game.
BEWARE OF “FINANCIAL ADVISORS” IN LOVE WITH ETFs
I began work as a financial advisor in 1990. I was just about the only practitioner at the time who worked solely on an hourly basis. Most of the fee-based advisors at that time managed their clients’ portfolios by using mutual funds. I was struck by the fact that many advisors didn’t use or recommend low-cost index funds. In speaking with some of these advisors, I got the sense that they were somewhat threatened by index funds because the investing process was so simplified that clients might question the value in paying the advisor an ongoing fee of about 1 percent to manage their money among funds.
Interestingly, some advisors now boast that they use ETFs as the investment vehicle to manage their clients’ portfolios. Ironically, they crow about the low cost of ETFs. Why do some advisors now embrace and tout ETFs when they didn’t advocate index funds? ETFs are complicated, and advisors feel safer using them and don’t worry as much about having clients feel that they could do this on their own. Advisors who charge ongoing management fees while using ETFs aren’t performing low-cost investment management. If the ETFs they’re using average about 0.5 percent in annual fees, paying the advisor 1 percent per year on top of that to shift your money around among various ETFs triples your total costs! See Chapter 23 for how to find a good advisor.