ETFs: Why so complicated? (pg. 2)

  @Money September 10, 2012: 3:02 PM ET

In a recent study Vanguard examined the performance of newly created indexes with at least six months of back-filled data and six months of actual returns. The results: While 87% of the indexes beat the overall U.S. stock market based on back-tested data, only 51% had the same success when they reported live returns. The average annual back-tested return was 10.3% for five years, but a miserable -0.93% for the five years after the indexes went live.

"They're choosing to create indexes that have performed well recently," says Joel Dickson, a senior investment strategist at Vanguard. "That doesn't necessarily mean they'll do well going forward."

What's more, Vanguard found that more than half of newly launched indexes had been around for less than six months before an ETF was rolled out to track it (S&P and MSCI are two of the most well known index creators).

"If you have a strategy, you can go to the index providers, have them build an index to replicate the strategy, and then launch an ETF around it," says Tom Lydon, editor of ETFTrends.com.

Best move: When you see a sparkling back-tested ETF portfolio return, proceed carefully. Same goes for a new ETF based on a newly created index. "Investors have a long history of throwing money at funds that have performed well in the past," says Dickson. Don't be that investor.

Making it hard to keep score

You can find stellar real-world returns in the ETF strategy world -- top global portfolio Glovista Global Emerging Markets Equities gained an annualized 16% before fees over the past five years.

The challenge is putting the results in context. ETF portfolios don't fit neatly into mutual-fund style boxes -- say, large-cap growth stocks. Those categories "were intellectual constructs of the mutual fund industry so that you could distinguish between managers," says John Forlines, chairman and CIO of JAForlines Global.

Related: 6 worst performing ETFs

With ETF portfolios, managers will compare their returns to some benchmark, such as the S&P 500 or an index of U.S. bonds or a blend they create, but the strategy could change so much that the comparison becomes meaningless. And without fund-like style boxes, you'll be hard-pressed to compare one manager with another.

Best move: The difficulty you'll have judging your performance is all the more reason to avoid fast-changing tactical strategies. With a more stable investment approach, make sure the benchmark fits your goals. Keep an eye on performance if the portfolio mix changes, says investment consultant David Spaulding, who is working to create an adviser reporting standard. "That's how you know if the changes helped returns or not."

Swinging for the fences

To sidestep shaky U.S. stocks, advisers and investors alike are snapping up ETFs that track foreign assets, especially markets you can't invest in through regular funds, such as frontier nations or global inflation-linked bonds. Also popular: alternative assets, or everything from copper to coffee.

The global flexibility of ETFs suits John Csenge, an adviser in Clearwater, Fla. For the past eight years he has been investing in a broad range of ETFs, including currencies and commodities, as well as stocks and cash. "We tend to be in the church of what's happening now," says the firm's investment director, Eric Caisse.

Related: 6 best performing ETFs

Focusing on your long-term worldly goals might be better than giving in to short-term temptations. By venturing into offbeat or narrow market niches, you're taking exotic risks. Consider the pain a concentrated ETF bet could be inflicting now: Global X China Consumer (CHIQ) is down 23% over the past 12 months; Market Vectors Coal (KOL) is down 39%.

The ETF universe is littered with even riskier and more complex funds -- inverse ETFs (designed to move in the opposite direction of an index), leveraged ETFs (aim to magnify an index return) -- virtually none of which are suitable for individual investors.

Many advisers steer clear of the latest and craziest rollouts. "We avoid some of the new ETFs that are not time-tested, says John Myers, a financial planner in Dresher, Pa. Not all pros have been as scrupulous.

In May the Financial Industry Regulatory Authority, which oversees brokerages, levied $9.1 million in fines and restitution against Citigroup Global Markets, Morgan Stanley, UBS Financial Services, and Wells Fargo Advisors for allegedly selling complex ETFs from 2008 to 2009 to investors for whom the ETFs were unsuitable and for not adequately supervising their sales forces. In the same month RBC Capital Markets agreed to pay $2.9 million for losses tied to inverse and leveraged ETFs, as part of a settlement with the Massachusetts Securities Division.

Regulators have issued warnings about the risks of certain ETF-like investments. In June, FINRA put out an investor alert about exchange-traded notes, which buy bank-issued debt whose value is tied to an index. "Some of the notices are reminders that advisers need to explain to investors how these complex products work," says Gerri Walsh, FINRA's vice president of investor education.

Best move: If you want to take a flier on a particular niche or industry, invest no more than 5% of your portfolio. Or look for a broad index ETF that holds a large allocation in the asset class you want -- Vanguard Total International Stock ETF (VXUS) stashes roughly 25% in emerging markets.

Piling on the fees

As a rule, ETFs are a bargain -- the average one charges 0.6% of assets a year vs. 1.2% for an actively managed fund, and you can pay 0.06% for a total U.S. market ETF. But enjoying those low costs is no sure thing.

You'll pay your adviser a percentage of the assets he manages, typically 1%, on top of ETF costs. Stick with low-cost broad-market ETFs, and you should be able to keep your total expenses below 1.5%. But working with a broker-dealer or outsourcing a portion of your portfolio to an ETF strategist keeps the fee meter running.

"This inexpensive indexing thing is costing your clients as much as 2%," says adviser Rick Ferri of Portfolio Solutions in Troy, Mich.

Of course, investing in actively managed mutual funds through an adviser can be costly too. "For people who used to buy actively managed funds, these ETF portfolios can be a deal," says Matt Hougan, president of ETF analytics at IndexUniverse. But since ETFs charge half of what active funds do on average, you'd expect to do far better.

Best move: Many advisers are worth their fees, especially if they keep you on track during trying times. Aim to keep your costs as close to 1% as possible. If you don't need day-to-day handholding, opt for a pro who charges a flat hourly rate. (At GarrettPlanning.com, the range is $150 to $240 an hour.) You may pay more upfront, but then you can wait a few years to pay again for a checkup.

Ignoring trusted veterans

ETFs are not the answer to every investing challenge. Take corporate and municipal bonds.

"During volatile times, liquidity for these bonds can dry up, which can lead to large price discounts or premiums during the day," says Ferri. Between October and December, iShares iBoxx $ High Yield Corporate (HYG) traded for as much as 3.5% above and 2.3% below the value of the assets it holds. With a regular bond fund, you can be assured of getting the full net asset value at 4 p.m.

In areas where an index doesn't do a good job of capturing a market's growth, a stock picker may pay off. "In emerging markets an active manager can determine if a company is a better choice," says Michael Kitces, director of research at Pinnacle Advisory in Columbia, Md.

Finally, the ETF cost advantage is not always compelling. You can find regular index funds that charge about the same as comparable ETFs. Schwab S&P 500 Index (SWPPX) charges 0.09% vs. 0.08% for Schwab U.S. Large Cap ETF (SCHX).

Best move: In the end, your big decision isn't whether to choose an ETF or a mutual fund. It's to figure out the best asset allocation and then pick the best investments. "Sometimes mutual funds are a better choice," says George Papadopoulos, a financial adviser in Novi, Mich.

Back in Kansas City, however, "The ETF Store Show" team is keeping up the drumbeat. Like a growing number of their peers, these advisers have sworn off traditional funds, fed up with underperformance and high costs, they say. No wonder the show kicks off every week with a riff from the Who's "Won't Get Fooled Again."

You shouldn't either. To top of page



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