ETF Trap?

Investing is a great way to increase your wealth, to get more for doing relatively little. But itís also a great way to loose money as anyone who bought internet companies just before the downturn knows. And itís not just extraordinary events like the technology bubble that can cost you your fortune, itís stupid mistakes like buying stocks without knowing much about the company, without doing the proper research. Then there are the unscrupulous people who are looking to cheat you.

But one danger that is perfectly legal but no less a drain on your wealth is the commoditization of investments. By this I mean that some investments are better at making brokers and advisors money than they are for you and me. (See this post for more on this subject.) I fear that ETFs are becoming such a commodity.

ETFs, Electronically Traded Funds, act like mutual funds in the sense that by owning an ETF youíre buying a basket of stocks that would be difficult to simulate on your own. ETFs act like stocks in the sense that they are traded throughout the day as their price fluctuates in the market. The concept makes perfect sense keeping fees low and allowing investors to buy at any time they choose rather than waiting till the fund prices at the end of the day.

In the beginning ETFs were very similar to index funds, tracking a particular index such as the S&P 500 or the Dow. Now, as John Spence of points out in this article, ETFs are increasingly focusing on niche markets just as the mutual fund industry has done. The problem I see with this strategy is the same that hounds the mutual fund business. Most mutual funds do no beat the index most closely aligned with their strategy over a long period of time.

"The number of ETFs tracking very narrow sectors is getting a little ridiculous," said Gus Sauter, chief investment officer at Vanguard Group, which manages both ETFs and mutual funds.

It's these intricate ETFs, which open up sectors and strategies previously difficult for individuals to access, that some analysts say could put investors at greater risk of losing money.

The importance of diversification can sometimes be overstated but that doesn't mean that an extemely narrow focus is the best antidote. In my opinion, as one tries to find the next hot sector, they miss the current hot area. Buying ETFs just because their particular focus seems attractive, without doing any research, is just as dumb as doing that with any stock or mutual fund.

"It's dangerous in a way if people are buying things they don't really understand," said Paul Mazzilli, an ETF analyst at Morgan Stanley.

A movement toward higher portfolio turnover and fees diminishes ETFs basic appeal, he added.

"We're just cautioning people to know what they're buying with the new stuff," Mazzilli said.

Speaking of fees. The whole lure of mutual funds, specifically no-load or index funds, is the low fees. Buying or selling a stock or in this case an ETF triggers a commission. If you do your homework, however, you can buy mutual funds without a commission. Combine that with low fees and your investment doesn't have to perform as well to begin turning a profit.

"If ETFs become products that are pushed or sold aggressively based on past results and not for their investment merits going forward, then those of us in the industry aren't doing our jobs properly."

ETFs are currently the hot item on the market but they're just another way to invest which also means they're just another way to get in over your head. Any tool is only as good as the person using it, so educate yourself before investing in something that might not make sense for you.