Three exchange traded funds you should avoid

Exchange traded funds (ETFs) are typically easy to understand, transparent and cheap. But there are some funds out there that traditional ETF investors should steer well clear of, says Tim Bennett. Here, he picks out three types of fund that should come with a health warning.

As a rule, we like exchange-traded funds (ETFs). They're transparent and easy to understand a typical ETF simply tracks the price of an underlying security, be that an index, sector, commodity, or currency. As a result, they are also cheap annual management fees are usually well below 1% and in many cases under 0.5%.

But as the industry has mushroomed global investment topped $1trn at the end of last year more esoteric products have been launched as fund groups try to take advantage of investors' interest in the sector. Some of them might have a place in the toolbox of a professional day trader, but for most traditional ETF investors, they should come with a health warning.

1. Futures-backed commodity trackers

The commodities market is on fire. All that cheap money created by central banks needs a home. With fear of inflation growing, commodities provide one. So it's no surprise that commodity-tracking ETFs are popular too. They come in various forms from ETFs that track a single commodity, such as gold, to those that follow a basket of agricultural commodities. But be careful. Bloomberg BusinessWeek has described certain of these products as "the worst investments in America".

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Why? Well, the commodity ETFs that we like such as many of the precious metals ones are physically backed by the actual commodity. So a gold ETF such as ETF Securities Physical Gold (LSE: PHAU) is backed by gold stored in HSBC vaults. However, many other commodity ETFs are backed by derivative contracts (futures or swaps) written on the underlying assets. This creates at least one big headache for an unwary investor: the ETF doesn't track the spot price of the commodity. That's because, in most markets, futures contracts are more expensive than spot prices for a commodity (because the future seller charges 'costs of carry', such as storage). This is known as contango and it means that as future contracts expire the fund has to sell them and buy new ones at a higher price than spot, creating a negative 'roll yield'. This cost is borne by investors. It means these sorts of ETFs are generally only suitable for short-term trades rather than 'buy and hold', or for those who understand the commodity markets and the products well.

2. Leveraged and inverse ETFs

These sound simple a twice-leveraged fund will give you twice the performance of the underlying asset. So in theory, for every 1% move up in the underlying asset, the ETF delivers a 2% gain, and so on. Equally, an inverse ETF offers retail investors the chance to go short without having to worry about the practicalities a two times inverse ETF delivers a 2% gain for every 1% fall in the underlying asset. Sounds simple. But it's not.

Many investors still don't understand the impact of daily repricing (see below). This can lead to a serious divergence between the expected and actual performance of an inverse or leveraged ETF. What's more, these products are more complex than ordinary funds, so they are more expensive. For example, the Powershares Short Gold ETF (NYSE: DZZ) levies a 0.75% annual fee versus 0.39% for an ETF Physical Gold.

3. Active ETFs

As we've already noted, a key draw of most ETFs is that you don't have to pay for a costly fund manager who'll probably underperform the market in any case. But now some providers are trying to ramp up fees by charging for an 'ETF with a brain'. After all, as the FT's David Ricketts notes, "the flood of money into ETFs and away from traditional, and more expensive, funds" isn't good for profits.

Active ETFs claim to offer investors a cheap way to track successful trading strategies. For example, Wisdom Tree plans to launch a fund offering hedge-fund-style 'absolute returns', while the Russell Global Opportunity ETF will work as a sort of 'fund of ETFs'. But while it's worth watching the long-term performance of these funds, we think that for most investors the extra cost and complexity defeats the point. Institutional investors first started using ETFs way ahead of the retail market precisely because they were cheap and simple. Why try to fix a model that isn't broken?

The trouble with leveraged ETFs

Take an ETF offering twice the daily performance of an index. Let's say the index starts at 100, then rises 10% one day, then falls 10% the next. The total cumulative change in the index is -1% (100 x 1.1 = 110 and 110 x 90% = 99). However, the ETF, priced initially at, say, £100, will gain 20% (2 x 10%) on day one to close at £120, then drop 20% on day two to close at £96 (120 x 0.8). So rather than losing 2%, it has lost 4%.

Now assume it was a 2 x inverse ETF and the index performs the same way to lose a cumulative 1% over two days. This time the ETF drops 20% (2 x 10%) on day one to close at £80. It then puts on a 20% gain on day two to close at £96 (80 x 1.2). That's a fall of 4%. Nothing inverse about that!

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.