Why I don't like ETFs

"I play that with ETFs" is a frequent comment I hear when people talk about their investments. Exchange Traded Funds as originally conceived (like the S&P 500 SPDRs) offered an inexpensive way to gain exposure to a popular index.

But we've moved well past that, and today there are hundreds of ETFs representing everything from Australian Real Estate to Japanese Appliances to Worldwide Water Resources.

I'm not a fan.


1) If you can't pick a stock, what makes you think that you can pick a sector? Often people invest in sector ETFs like biotech or semiconductors because they like the industry but don't want to take the risk of owning the wrong stock (i.e., one which underperforms). I would much rather own a company than an industry. The sector ETF is a diversification strategy, which will reduce your risk of that 50% plunge in a stock when news breaks that the Phase III trial for the lead drug has failed. But diversification works in both directions, reducing both losses and gains. My answer is to not buy a stock with that much risk. If you like biotech, look for some leading biotech stocks. If you can't find any individual stocks that you're willing to invest in, what makes you think that you'll make money with a bunch of them?

2) Do you know what you own? I'll bet that most investors in sector and country ETFs can't name most of the stocks in the ETF. And if you saw a list, there's almost certainly some that you wouldn't consider buying as an individual holding. So why tolerate holdings in your portfolio that you don't like?

But the bigger "know what you own" problem comes with the more exotic ETFs. Let's start with gold. If you own a long gold ETF, you probably want the protection that gold has historically offered in times of great financial stress. But who guarantees your investment if things get really bad? Some financial firm like Bear Stearns or AIG? Citibank? Lloyds of London? And how do you know that there's actually real gold backing your investment? Lots of recent news about once-trusted financial entities that met "black swan" fates. Same goes for other commodity ETFs: do they really own that oil, or corn, or copper?

And then we come to the leveraged ETFs, the "double long" and "triple short" variety. Have you ever asked the sponsors how they manage their positions? It's not simply a matter of buying or selling stocks equal to the ETF position. They use derivatives, and one thing that we've learned in the past year is that derivative instruments can sometimes have unintended consequences. A friend once called one of the sponsoring firms to get the details on how they managed the fund. He was told that they did not disclose that information. So how do we know that, when oil plunges from 147 to 32, your short oil ETF doesn't go bankrupt because of bad hedges?

Quiz question: If I was smart enough to have invested in the double-short Financial Sector ETF (symbol SKF) on the first trade in January 2008 and held that position through the year, how much money would I have made? We all know that financial stocks had absolutely miserable performance in '08. So by being double short, I must have killed it, right? Actually not. In fact, the SKF rose from 99.88 to 103.01 in that 12 month stretch (plus a small dividend). Check it out. The math is a bit complicated, but let's just say that the up days hurt more than down days help. Same thing is true for many leveraged ETFs. My point is that many investors don't really know what they own (until they learn an expensive lesson).


Portfolio update
I'm putting PG on the watch list. It's a great company, and it meets most of my criteria, but until now the stock hadn't come down enough to get me interested. With yesterday's selloff, I'll be looking for a chance to buy it if it continues to decline.