In the technology sector, innovation is routinely embraced. In the finance sector? Not so much. And for good reason, too.
Whereas new technologies tend to improve our lives, new financial instruments often hold lopsided potential to ruin our lives. And, unfortunately, regulators are notorious for not keeping up with the financial wizards on Wall Street.
So by the time they uncover the pitfalls behind these new ideas – and implement safety measures to protect the little guy – we’ve already paid the price. I bring this up to reveal an alarming truth: A clear and present danger exists in an increasingly popular area of the market, which many investors naively believe is perfectly safe.
Yet, as one insider recently confessed to Barron’s, a “tidal wave” of innovation is approaching. And at least 25% of it promises to be “silly or toxic.” Newsflash: We have no need for either in our portfolios.
Once again, we can’t count on the regulators to protect us. So it’s time to get informed and be on guard; or be sorry.
The Dark Side of ETFs
Exchange-traded funds (ETFs) have been heralded as a great leap forward for the individual investor. I’ll concede, they provide notable advantages over traditional mutual funds. Advantages like lower expenses, intra-day liquidity and increased transparency.
They also provide quick and easy access to areas of the market that we may find compelling, yet don’t have the time to properly research to uncover individual opportunities. Areas like biotech and pharmaceuticals, for example, which were red hot in 2013.
As longtime analyst, Les Funtleyder, says, if you’re not a specialist;
The fastest way to get an equal-weight or overweight exposure is through ETFs.
ETFs also provide access to traditionally high-volatility investments, like commodities, without all the risk.
Take, for instance, the GreenHaven Continuous Commodity Index Fund (NYSEARCA:GCC). It holds futures contracts on 17 commodities and weights them equally. As a result, it reduces the drama associated with big, unpredictable moves in individual commodities on any given day.
It’s no wonder, then, that ETFs continue to increase in popularity. Consider:
- Investors plowed over $180 billion into ETFs in 2013 alone, according to Bloomberg data. That’s more than triple the amount of inflows in 2004.
- Since the first ETF, the SPDR S&P 500 Fund (NYSEARCA:SPY), launched in 1993, investors have dropped $1.7 trillion into 1,500 different ETFs.
- By 2025, experts expect the ETF industry to balloon to $15 trillion in assets, thereby eclipsing the mutual fund industry.
Of course, such growth can’t come without continual new product offerings. And that’s where the danger lies.
All is Not Well
Last year, more than 150 new ETFs were launched. So far this year, another 50 or so already started trading. But, as Matt Hougan, President of ETF.com, told Barron’s recently:
If you think we’ve seen a lot, just wait. The tidal wave is approaching.
And Hougan estimates about a quarter of the new launches can be categorized as "silly or toxic."
I’ve got nothing against Nashville. And such slicing and dicing of the markets into smaller and smaller segments is inevitable over time. Ben Johnson, Director of Passive Fund Research at Morningstar, Inc. says:
The first ETFs are done at a very high level and others get finer and finer as needs dictate.
But there’s no enduring need for any ETFs focused on that small of an economic region. Sparse liquidity since the NASH fund’s August 2013 launch – including multiple days without any trades at all – proves my point perfectly.
Now, when it comes to the toxic category, the leveraged funds I previously warned you about are perfect examples. However, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) is especially toxic. Says Hougan:
It’s an inferno for investor capital.
Exaggeration? Hardly! The fund has attracted more than $6 billion in assets. But – get this – it’s down more than 99% since it launched. I don’t think that’s a financial “innovation” anyone can embrace.
Bottom line: The SEC is just now getting around to revising a 2008 rule to address potential ETF risks related to inverse leverage, flexibility in investment choices and transparency. I don’t recommend you wait for them to figure it all out, though. It’ll be too late!
Instead, it’s imperative that we do our own due diligence before investing in any newfangled ETFs. Otherwise, we’re bound to pay a stiff penalty for believing the marketing hype and buying into a new fund blindly.