How To Discern A Plain Vanilla ETF From One That's Riskier

 |  Includes: FAZ, IWM, QAI, VTI
by: Wealthfront

By Elizabeth MacBride

The fallout is beginning. Because Kweku Adoboli, who allegedly used unauthorized and speculative trading techniques that cost UBS $2.3 billion, was an ETF trader, some people are drawing the conclusion that ETFs are dangerous.

This is a simplistic view. Just as investors should not naively embrace ETFs as a category, they should not naively reject them as a category.

“In its basic vanilla form, the ETF idea is a sensible one and very useful for investors,” writes Gillian Tett, The Financial Times’ U.S. managing editor in a column that also warns of the danger of the complex ETFs. (Registration required).

ETFs began as funds (they are technically a kind of mutual fund) that track indexes. Those index-tracking funds are often very inexpensive, and can provide the core holdings of a portfolio. The fact that ETFs can be traded throughout the day is not of concern to investors with long-term strategies.

As ETFs became more popular, the financial services industry began introducing more complicated funds. Now, you can find ETFs that track, say, alternative investment strategies and that use derivatives and debt to multiply their returns.

The North American State Securities Administrators issued an advisory not long ago in which they warned investors about exotic ETFs and identified the common, traditional ones:

Index – Seeks to mirror the performance of a specific investment index, such as the S&P 500 or the Dow Jones Industrial Average.

Commodity – Seeks to mirror the performance of a specific commodity or commodity group, such as gold or oil.

Bond – Seeks to mirror the performance of a specific bond index or product, such as U.S. Treasury or municipal bonds.

Currency – Seeks to mirror the performance of a specific currency or basket of U.S. or international currencies, such as the Euro or Yen.

Industry – Seeks to mirror the performance of a specific industry segment, such as healthcare or manufacturing.

Practically speaking, you can be reasonably sure you’re looking at a plain vanilla ETF if it tracks an underlying index that you’ve heard of. Another sign that you’re dealing with a plain vanilla ETF is that its tracking error is low. See our post on Four Keys To Choosing An ETF.

Quick – can you tell a plain vanilla ETF from one that’s not? Here’s a selection:

- iShares Russell 2000.
- This fund tracks the well-known index of small company stocks.
- Vanilla

- Direxion Financial Bear 3X Shares
- Morningstar says this is for investors seeking leveraged exposure to the financial services industry.
- Clearly NOT plain vanilla

- Vanguard Total Stock Market ETF
- This fund tracks the entire U.S. stock market.
- Vanilla

- IQ Hedge Multi-Strategy Tracker ETF
- This fund tracks alternative investments in commodities and fixed-income securities.
- Not plain vanilla

If you don’t have time to pick the vanilla ETFs from the riskier ones, hire someone who does. But know enough to be able to tell if your advisor is doing a good job. (See 10 Signs Of A Bad Investment Advisor).