Exchange-Traded Funds: The Hidden Risks

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Brendan McDermid / Reuters

Traders work on the floor of the New York Stock Exchange

Retail investors may still be cool to the stock market, keeping much of their savings in cash equivalents, but they are warmly embracing a relatively new investing tool — exchange-traded funds, or ETFs — hoping to find growth in a ho-hum market and keep costs down.

The number of ETFs in the U.S. market shot up to 934 in 2009 from 154 in 2004, according to Larry Petrone, director of research at Financial Research Corp. Over that time, ETF assets under management have more than tripled, to $742 billion. That's still far short of the $7.14 trillion in assets held by mutual funds, but the ETF growth rate is fast closing that gap, with new products covering every subsector of the markets, from bank stocks to silver to Vietnam's public companies.

Basically, ETFs are baskets of securities that passively track stock-market indexes or financial indexes. Since ETFs mirror indexes, they don't have big management fees, nor do they generate as much trading volume (and commission costs) as actively managed mutual funds; when they do have portfolio turnover, it is often by swapping stocks instead of buying and selling them, which means they don't run up capital-gains taxes the way mutual funds often can. The result: lower overall costs for investors. The average annual fee for an ETF is 55 basis points (i.e., 0.55% of assets), significantly below the average 1.5%-of-assets charge from mutual funds, says Scott Burns, director of ETF research at Morningstar.

Since most ETFs only mirror a market index, such as the S&P 500, they won't outperform the index. But increasingly, investors see that outperformance quest as more of a pipe dream. "Only 20% of [mutual-fund] portfolio managers actually beat the index that they're tracking," says John Spallanzani, director of ETF sales and strategy at GFI Group. "So if you put your money in an ETF, you're basically beating 80% of the mutual-fund managers out there." ETFs are also more liquid than mutual funds, because they can be bought, sold or shorted throughout the trading day, just like stocks. By contrast, mutual funds offer only a single price at the end of the trading day.

Yet for all their benefits, ETFs come with their own set of risks. For example, Tad Borek, an attorney and registered financial adviser in San Francisco, advises clients to avoid oil-and-gas ETFs because they track futures indexes. "You can lose a lot of money [in futures] even though the price of oil is going up," he says.

Advisers also warn investors to choose larger ETFs over smaller start-up ones, especially when it comes to global and emerging-market funds. Unlike mutual funds, investors face price spreads when buying and selling ETFs, and these spreads can be quite wide — spanning several percentage points in some cases — when the ETF is small or its underlying stocks don't trade much.

A large spread can effectively wipe out any cost advantages over mutual funds. "You might save 20 basis points [i.e., 0.2 percentage points] on the cost of the ETF, but what if you're paying 200 basis points [2 percentage points] more because of the trading spread?" asks Borek. The spread risk is exacerbated in emerging markets and specialized niches in the global markets, where data are scarce and trading is limited.

More recently, the investor spotlight has been shining brightly on a new line of ETFs — ones that are actively managed. Firms ranging from Invesco to Pimco have launched about 12 of these funds over the past two years; others, such as T. Rowe Price Group and John Hancock Funds, are preparing to roll out similar funds, all in an effort to go head-on against actively managed mutual funds. "It's clearly a category that's attracting more interest among ETF providers and mutual-fund companies," says Standard & Poor's Tom Graves. "It combines the characteristics of a passive, index-based ETF with that of an actively managed mutual fund."

However, experts caution investors not to blindly move cash into these vehicles until some of the kinks are worked out and their performances are tracked over several years. "Ideally, I would like to see three to five years" of outperformance before jumping in, says Nadine Gordon Lee, a CPA and the president of ProsperAdvisors.

Active ETFs would likely require higher fees than passive ETFs because the active players need to cover research and commission costs, although most experts believe the fees would still be cheaper than those charged by mutual funds. Among the currently offered active ETFs, annual fees range from a low of 0.35 percentage points to a high of 1.6 percentage points.

Fees will clearly vary depending on the size of the fund as well as the fund manager's trading activity. In some cases, managers may occasionally adjust the weightings of certain stocks within an index, while others may aggressively manage the portfolio every day, all of which could affect fees. Before buying, experts advise scrutinizing the active ETF's fee structure and to check the fee frequently — since fund companies may offer a low fee up front to attract investors, then raise it later on.

An even bigger concern is that active ETFs must disclose their holdings daily rather than quarterly as mutual funds do. Although this makes the ETF more transparent, it also opens up the ETF to the risk that savvy hedge funds and others may snap up shares in a stock that an ETF is known to be moving into. This practice, known as front-running, could drive up the stock price and thereby dull the ETF's performance.

In the end, if your goal is to beat an index, a good low-cost mutual fund may still have the edge. Says Lee: "I would rather buy a known management team and pay a slightly higher fee in a mutual fund than rush to an ETF structure just for lower fees."