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By David L. Allison, CFA, CIPM

By now, most investors are familiar with the sales pitches in favor of exchange-traded funds (ETFs). Proponents of ETFs are quick to point out the greater transparency, costs savings, diversification, and tradability that they offer relative to other investment products.

All of these features sound empowering in advertisements, but tradability - the most popular one - may be a curve ball for individual investors.

According to a recent survey by Charles Schwab, individual investors said that the top feature of ETFs is that they can be traded intraday like stocks. When given a choice of nicknames for ETFs, 57% of respondents selected the name "easily traded funds." Survey respondents also suggested that they want to be able to trade ETFs quickly and cheaply.

Nearly half of respondents claimed they would not buy a commission-free ETF that assessed a fee for selling too early ("too early" at most discount brokers is around 30 days after purchase). In addition, the survey found that individual investors favor ETFs linked to narrow sectors of the market over those that have more diversified equity and are international.

In sharp contrast to the speculative mentality demonstrated above, most of the same survey respondents said ETFs are best suited for long-term investors. On top of that, most were confident in their knowledge of ETFs. Only 31% said they needed to know more about ETFs to invest more money in them.

Although most individual investors claim to understand ETFs, it seems many of them do not have a good grasp on the difference between investing and speculation.

To a long-term investor, buying an index fund predominantly because it trades like a stock makes about as much sense as a batter bunting with a two-strike count. So, before you take a swing at building a portfolio of ETFs, there are three straight-down-the-middle pitches you may want to consider.

Increased Tradability May Be Hazardous to Your Wealth

Numerous studies support the notion that, depending on your personality, increasing your ability to trade will actually decrease your investment returns. For example, the study titled "Online Investors: Do the Slow Die First?" found that investors who switched from phone-based to online trading bought and sold investments more actively and less profitably than before. The authors claimed that overconfidence, coupled with the lure of cheaper and easier trading, explained the increase in speculation and trading as well as the impaired performance investors experienced after venturing online to trade.

A more recent study titled "The Dark Side of Index Funds and ETFs" concluded that individual investors worsen their portfolio performance after using index-linked funds and ETFs compared with non-users. The authors of the study asserted that easily tradable index-linked securities tempt investors toward market timing, which is the primary cause of ETF users' underperformance.

If you are easily coaxed into trading, the lure of intraday tradability could negatively outweigh the benefits of ETFs relative to other investments.

Successfully Trading Sectors Is No Walk in the Park

ETFs linked to specific sectors, such as energy or health care, make up a large portion of the funds available to individual investors. It is no secret that betting on entire industry sectors offers diversification and requires less company-specific research relative to betting on individual stocks.

If you have been burned trading stocks, then you may feel more comfortable in your ability to successfully trade sector-linked ETFs. But research shows that correctly timing when to trade sectors can be a challenging endeavor, regardless of whether you are gaming economic scenarios or technical patterns.

Trading sector-linked ETFs based on your economic predictions is an uphill battle for two reasons. First, it is almost impossible to consistently forecast where the economy is headed. Second, many stock market sectors have a spotty record of performing consistently and significantly better in different stages of the business cycle.

Consider the study titled "Sector Rotation over Business-Cycles," in which researchers found little support for the notion that you will significantly outperform the market using a conventional sector rotation strategy across business cycles. Even when they assumed that an investor had perfect economic foresight and ignored transaction costs, the conventional strategy barely outperformed the broad market.

Flipping in and out of sector-linked ETFs based on technical analysis may seem more cut-and-dry. Researchers have argued that investors can use sector rotation to exploit such technical anomalies as the momentum effect. In fact, a recent study titled "Can Exchange-Traded Funds Be Used to Exploit Country and Industry Momentum?" concluded that investors are able to use ETFs to benefit from momentum effects in both country and industry portfolios.

But investing based on technicals alone has its hang-ups. For instance, research suggests that simple momentum-based trading strategies perform poorly in choppy markets and tend to get crushed just after major market reversals. Adding to the challenge, back-tested trading schemes that claim to help you identify when markets will suddenly become choppy or have a major directional change are almost always fool's gold.

It is true that ETFs make it easy to trade entire sectors of the market. But correctly timing when to make those trades is an entirely different ball game and probably not much easier than correctly timing when to trade individual stocks.

Most Exotic ETFs Are Designed for Traders, Not Investors
According to Index Universe, just 30 of the 1,525 ETFs available in the United States claim about half of the industry's total assets under management. Most of the largest 30 funds are based on simple indices that select and weight securities by market capitalization.

You do not have to venture far away from the industry's tallest trees to get lost in a thorny thicket of exotic ETFs. Many of these exotic ETFs are repetitive, serve specific niches, or are just plain wacky and designed for speculators rather than investors.

Consider leveraged and inverse ETFs. They may sound enticing given their stated ability to hedge or magnify your investment returns. But as FINRA (Financial Industry Regulatory Authority) points out, there are dangers to holding them long term.

The problem is that most leveraged and inverse ETFs "reset" daily, meaning they are designed to achieve their stated objectives on a daily basis. When held over longer periods of time, their returns can deviate significantly from the performance (or inverse performance) of the underlying index. You could actually lose money investing in these products even if the underlying index you are betting for or against goes your way.

The ancient lesson "there is nothing new under the sun" applies here. Do you remember when asset-backed securities (ABS) were considered a breakthrough financial innovation because they offered instant diversification and the ability to trade large baskets of loans quickly in a single trade?

Sound familiar?

Regardless of these empowering features, sophisticated financial institutions still lost heaps of money betting on exotic versions of ABS without fully understanding them. Exotic ETFs may be good for short-term hedging or speculation, but they can be some of the worst investments in the world if held over longer time horizons.

In conclusion, the freedoms that financial innovations allow require you to exercise a higher level of discipline. ETFs have some great features and will benefit investors. But do not let a financial engineer's seasoned pitches of empowerment and control trick you into speculating when you think you are investing.

Before you invest in any new financial product, take a moment to write down your beliefs and the process behind your decision. If they are similar to the beliefs and process you used to make investment decisions in the past, then you are probably in for similar investment outcomes, regardless of what kind of sales pitch Wall Street throws you.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: The Most Popular ETF Pitch Is Likely A Curve Ball