Avoid ETFs tracking obscure sectors or indices
ETFs have proliferated to such an extent that Vanguard’s founder John Bogle once sarcastically wrote in a Wall Street Journal op-ed: “Can you believe we now have an Emerging Cancer ETF?” That ETF, among others, has since closed after either failing to attract enough assets or after delivering poor returns to investors.
You should also be aware that Bogle has said that individual sector and country ETFs are probably “too narrow for most” investors, although there might be times when such investments make sense.
Stick with “plain vanilla” ETFs
There could also be times where having a small position in so-called “inverse” ETFs (which short the market), leveraged ETFs (which use leverage in an attempt to generate outsized returns), or those tracking non-traditional assets (commodities), can make sense.
However, you need to understand these ETF investments come with added and potentially significant risks. Vanguard’s Bogle has gone so far as to say that inverse and leveraged ETFs are where the “fruitcakes, nut cases and lunatic fringe” can be found.
Avoid illiquid ETFs
A major problem with ETFs tracking obscure sectors or markets, along with some inverse or leveraged ETFs, is their lack of liquidity -- because not many investors or traders are buying or selling them. This lack of liquidity could lead you to pay too much to buy and sell them.
Read the prospectus
The good thing about most plain vanilla ETFs is that they are fairly straightforward investments – meaning even less-experienced investors should be able to read the prospectus and understand what they are doing.
However, if reading the prospectus leaves you confused, or if the prospectus is not well explained in plain simple English, you should find another ETF to invest in.
Be very careful when investing in commodity ETFs
There are two types of commodity ETFs – one type owning the physical commodity (say, gold bars), and the other type owning commodity futures contracts (not physical assets). In the latter case, you need to read the prospectus carefully to understand the risks involved.
Moreover, be aware that since commodity ETFs do not invest in securities, they tend to be regulated differently or are less regulated than other investments.
Avoid high-fee ETFs
Most big ETFs on the market today will charge fees as low as the 0.04 to 0.25 per cent range, but there are some ETFs out there, usually “managed” ones, or those with more exotic investment strategies (for example, they invest in commodities, short the market or use leverage) which might charge fees as much as 1 or 2 per cent, even more.
If the credit crisis taught us anything, it is that the majority of investors do not read prospectuses. The ETF sector is proliferating and since fees are generally low, providers launch multiple strategies. They hope that some will capture the imagination of investors and assets under management will climb which is where their profits originate. Often the idea for a fund is based on the company’s ability to market it rather than on the mechanics of managing it. Concerns surrounding trading costs, liquidity, breadth and contango are too often ignored. I agree that ETFs offer wonderful opportunities to gain exposure to sectors which were once the preserve of highly sophisticated investors. However it pays to know exactly what one is buying.Back to top