Innovation is a good thing but can it be taken too far?
The exchange traded fund business started with simple index funds pegged to popular benchmarks. However, the industry has morphed into debt notes and derivatives-based tools.
"Derivative-based ETPs and ETNs have swelled since they were introduced in 2006," Bloomberg reports.
State Street Global Advisers launched the first exchange traded fund in 1993, the SPDR S&P 500 (NYSEARCA:SPY), giving investors the diversification benefits of a total portfolio at a very reasonable cost. Over the past 20 years, the industry has transformed, with "exchange traded products" taking over the landscape.
The exchange traded note, an offshoot of an ETF, includes debt securities, or notes, taking the place of stocks in the index. Traders have also enjoyed tools that give double or triple the returns of a traditional fund and even the ability to play on fear or volatility, reports Kyle Woodley for InvestorPlace.
Here are types of funds everyday investors should avoid or at least approach with caution:
- Double Dividend Funds: These exchange-traded notes are just like any other ETNs in that their performance is tethered to an index, sure, but they're debt securities to the core. Further, these funds can potentially track their intended index much differently than one may expect. ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (NYSEARCA:DVYL)
- Other ETNs: Some of these notes track much differently than the sector or title intends, so much research and babysitting is needed, on a daily basis. For example, iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEARCA:DJP) or the iPath MSCI India Index ETN (NYSEARCA:INP) can show performance that diverges from a comparable ETF.
- Hedge Fund Alpha ETFs: This ETF tracks positions that successful hedge fund managers are in. However, the problem is AlphaClone Alternative Alpha ETF (ALFA) can only track these acquisitions once they've been disclosed, which usually doesn't happen until months after a position has been initiated.
- Frontier Market ETFs: Because they're lesser-developed markets, frontier markets have the potential for explosive growth. However, they also involve countries with looser corporate regulations and often extreme political volatility, and many of the companies release much less information than is available from more developed countries' businesses. Approach funds such as Guggenheim Frontier Markets ETF (NYSEARCA:FRN) with caution. This sector is a high-growth gamble.
Tisha Guerrero contributed to this article.
Additional disclosure: Tom Lydon's clients own SPY.