The Case Against (Some) ETFs

Perhaps it's inevitable that love for the "next big thing" eventually gives way to skepticism. It's as true for investing tools as anything else. Just look at the current scrum forming around exchange-traded funds. Touted by financial advisers and the press as a revolution in transparency, cost, and access to exotic investments, these index funds are now being slammed from several quarters for inefficiencies, hidden fees, and opaque structures. Pundits have been mixing it up in sometimes shrill broadsides, with some arguing that ETFs are just the latest means for investment advisers to hoist flawed products on unsuspecting customers. The volume of criticism is up, even among industry experts.

So, ETFs: miracle or menace? Decidedly, opinion should tilt towards the former. As the funds evolve from cheap tools for tracking major indexes into a vast forest of products used to trade everything from commodities to countries, there are bound to be some successes and failures in what is still a relatively young asset class. As such, it's worth revisiting a few of the more frequent criticisms of the ETF, and what investors need to know about one of investing's most popular innovations in decades.

[See 9 ETFs for 2009 (and Beyond)]

Tracking Error. Perhaps the most oft-repeated criticism of ETFs is that they don't live up to their reputation as passive index trackers and sometimes miss the mark when it comes to closely following the actual indexes they're designed to replicate. ETFs are sold largely as passive investments, so the implication is that your investment will track its index minus management fees and taxes in a very tight range. In fact, ETFs never perfectly track their underlying indexes, but they do get close much of the time.

In 2008, the average tracking error for U.S.-listed ETFs was 52 basis points, with the widest spreads on fixed income and sector or industry funds, according to research by Morgan Stanley. Still, the number of ETFs with high tracking error (above 150 basis points) increased by 25 from 2007, most likely as a result of last year's record market volatility and a growing number of highly specialized funds more prone to such errors. A few factors, including rebalancing or diversification requirements for ETFs, can skew results. Rob Leiphart, an analyst at Birinyi Associates, says anything over 10 basis points above and beyond the management fees should raise alarm bells.

Some tracking error rules of thumb: The less liquid the underlying securities are, the higher the tracking error will be. It's easier to mimic hundreds of hotly traded stocks with hefty volume than, say, an index of just a few dozen high-yield bonds that may not even trade every day. The trade-off for investors is this: ETFs offer an affordable way to buy into a whole new universe of investments like sectors and industry funds, but tracking error can sometimes add to the cost of the total investment.

[See ETF Investing: 5 Pitfalls to Avoid.]

Index composition. "Buyer, beware" is a common enough sentiment on Wall Street, but with ETFs, it's more a case of "buyer, be wise." You'd (one hopes) never buy a traditional mutual fund without checking out its holdings, and the same goes for ETFs. The composition of similar-sounding funds can vary widely. For example, Vanguard points out that its Vanguard Emerging Market ETF has 791 holdings versus 338 holdings in its iShares counterpart. Another example: The popular Technology Select Sector SPDR fund (symbol XLK), one of nine sector funds that cover the whole of the S&P 500, underperformed its corresponding S&P sector by 3.93 percent between the start of the year and May 11, in part because the SPDR index includes both technology and telecom stocks, Leiphart notes. It all gets a bit complicated: SPDRs actually track AMEX Select Indexes that correspond with S&P 500 sectors but can include different stocks (in this case, those eight telecom names). "That's one major, glaring issue," he says. "These AMEX indexes are supposed to be a mirror of the S&P 500 indexes, but they're not."

Remember: Fund composition is carefully spelled out in every ETF's fine print. Industry leaders (iShares is a standout) go out of their way to make the distinction clear and offer resources and tools to follow tracking error, index composition, and overall returns. The question is whether or not everyday investors are taking the time to dig that deep.