The Case Against (Some) ETFs

[See 5 Steps to Setting Up a Retirement ETF Portfolio.]

The trouble with oil. Commodities present a unique twist on the indexing problem. Take oil: If you looked at the price of crude at the start of the year, saw room for a jump, and bought a popular oil ETF to take advantage of the big rise in oil prices during 2009, you already know what's wrong with some commodity ETFs. Between the start of the year and June 1, crude prices rose by almost half. But the popular United States Oil Fund (USO) barely budged into double-digit gains, rising just 13 percent. The reason? USO is supposed to track the price of West Texas Intermediate Light crude. Except it isn't, exactly. USO tracks crude futures, which means the returns for the index will follow futures prices, not spot prices. When the two diverge notably (known as contango or backwardation, depending on the direction), the indexes diverge as well (for more on the market impact of oil ETFs like USO, see this post from the Financial Times.)

International funds. If your ETF is tracking shares of companies listed in, say, China, and the Chinese exchanges are closed, why is your U.S.-listed ETF still bouncing around intra-day? Again, it's because ETFs are trading accessibility for exactness, which is part of the reason most folks buy them in the first place. What you need to know about such international funds is this: "International [funds], especially in emerging markets, will have larger tracking error in part because the indexes are harder to track, especially in subsections and sectors," says Kyle Waller, an ETF analyst at Wiser Wealth Management. Since ETFs based on foreign shares trade on U.S. exchanges when foreign markets are closed, managers hedge using "fair market pricing" to approximate index changes. They'll reorder the net asset value of a fund if market-moving news hits, or use a mix of U.S.-listed shares of foreign companies called American Depositary Receipts to smooth the changes.

Leveraged funds. Possibly the wildest corner of the ETF market is those funds that promise to double or triple returns on their underlying indexes. Leveraged ETFs come in various shapes and sizes, ranging from the usual round of major indices to sectors like financials or real estate stocks. For example, the Financial Industry Regulatory Authority notes that between Dec. 1, 2008, and April 30, 2009 "an ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent." FINRA recently reminded its members of their responsibility to have a "reasonable basis" for recommending such products to customers. Again, they're meant for day-traders only since volatility in the shares can wreak havoc on your returns if you hold such securities for any meaningful period of time (to be safe, "meaningful" means more than a day).

ETFs let you trade all day long. But should you? Lastly, there's a philosophical disconnect between the idea behind ETFs and how they're being used by traders. Index funds were developed to offer an option for folks who believe you can't beat the market over the long run, but have actually expanded the universe of tools available to try to do just that. Vanguard Group founder John Bogle recently took aim at ETF investors' trading habits, analyzing annualized five-year returns for 79 funds against models designed to replicate investors trying to time the market. He found that ETF investors, in part because of more frequent trading, lagged the market in 68 of the surveyed funds, sometimes by a wide margin. They underperformed the market by 0.4 percent per year in large-cap value funds to as much as 17.9 per year in financial ETFs. He found that investors fared worse in hot sectors like emerging markets, financials, and REITs. Because they're easy to trade, ETFs give index investors a chance to trade more actively. As a consequence, as Bogle put it, "passive indexing has gotten a lot more like active fund management."