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October 31st, 2014

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10 Worst ETFs

Kaitlin Pitsker

By Kaitlin Pitsker

Published August 20, 2014

10 Worst ETFs

When SPDR S&P 500 ETF, the first exchange-traded fund, made its debut in 1993, Whitney Houston topped the charts, shoppers were snapping up Beanie Babies and Cheers was in its final season. The newfangled gizmo was an immediate success. By the end of its first year, SPDR S&P 500 (SPY), which tracks Standard & Poor's 500-stock index, held $500 million in assets. But that was only the beginning. The number of ETFs and similar products today has swollen to more than 1,600, with combined assets of $1.8 trillion.

The first ETFs clearly filled a need. They provided investors with low-cost vehicles for tracking well-known market benchmarks such as the S&P 500 and the Nasdaq Composite index, while allowing investors to get in and out of a fund anytime throughout the trading day.

But with success has come excess. Hallmarks of many of the latest exchange-traded products are complexity, narrow focus and heightened risk through the use of leverage. In other words, many of these gadgets are dangerous to your financial health.

With that in mind, we've come up with a list of 10 categories of exchange-traded products that you rarely want to put in your portfolio.

Leveraged ETFs

What are they? Also known as ultra funds, these investments aim to return double or triple the return of the underlying index.

Why you don't need one: Do you really have the fortitude to stick with an investment that gyrates two or three times more than the index it tracks?

Moreover, because of the way they're structured, leveraged funds can promise to match their index only on a daily basis. And that can lead to some ugly math. With a leveraged ETF you can make the right call on the direction of a particular index but still lose money over an extended period of time. For example, in 2011, ProShares UltraPro S&P 500 ETF (symbol UPRO), which seeks a return of three times its benchmark, lost 11.9%, while the S&P 500 gained 2.1%.

Who are they for? Traders with short time horizons and cast-iron stomachs. Clairvoyants, too.

Inverse ETFs

What are they? These ETFs are designed to return the opposite of the index they track -- aiming to benefit from a decline in the market.

Why you don't need one: Divining the direction of a market is tough enough. Betting against a market or a particular index is even tougher, even when it looks as though it's sure to go down.

Consider what has happened to investors who have been bearish on the U.S. stock market in recent years. And there have been plenty of reasons for negativity, including global turmoil, dysfunctional leadership in Washington, D.C., and one of the weakest economic expansions ever. Pessimists might have had good reason to buy into ProShares Short S&P500 (SH), which is designed to return the inverse of the S&P 500 index. But since the current bull market began in March 2009, the ETF has lost 75% of its value (or 22.4% annualized) through August 13, 2014.

As with leveraged funds, inverse ETFs can deliver the promised inverse return only on a daily basis. Again, that can lead to disappointing returns over longer periods. In 2008, for example, the MSCI Emerging Markets index lost 53.2%. But ProShares Short MSCI Emerging Markets (EUM) returned only 19.6%. And in 2011, when the Dow Jones U.S. Financial index lost 12.8%, ProShares Short Financials ETF (SEF) gained a paltry 2.0%.

Who are they for? Traders who want to make a short-term bet on a market downturn. Investors sitting on big short-term profits could also use inverse ETFs to cut their tax bill. Say, thanks to a powerful bull market, you have a 30% gain on a stock fund you've held for 11 months. You'd like to hang on a bit longer to qualify for favorable long-term capital-gains treatment, but you're worried that a market correction could begin at any moment. To protect your gains, you could buy an ETF that moves in the opposite direction of a stock market index, hold it for a month and a day, then sell both it and your original investment.

Leveraged Inverse ETFs

What are they? These investments aim to return two or three times the opposite of the index they track.

Why you don't need one: It's one thing to bet against the market to hedge your portfolio if you feel certain a downturn is coming. But why double or even triple down on that stance? These ETFs carry the perils of both leveraged ETFs and inverse ETFs. And if you invest in a leveraged inverse stock ETF, the odds of making money over the long haul are slim because stocks always rise over the long term. ProShares UltraShort S&P500 (SDS), an ETF that seeks twice the inverse of the return of the S&P 500, illustrates the dangers. Over the past five years through August 13, it lost 85.7% of its value (32.2% annualized). Over the same period, its benchmark gained an annualized 16.4%.

Who are they for? Big-time bears with a lot of conviction.

Exchange-Traded Notes

What are they? As close cousins of ETFs, ETNs seek to match the performance of an index. They charge low fees, and you can trade them throughout the day. But ETNs don't actually own a portfolio of stocks or anything else. Rather, ETNs are unsecured debt, usually issued by an investment bank that promises, upon the note's maturity, to give you back your original principal, plus or minus the index's return over the lifetime of the note.

Why you don't need one: In addition to your other investment concerns, do you also want to worry about whether an ETN's issuer can survive the next financial crisis? In 2008, Lehman Brothers, which had issued three ETNs, failed. Investors who held those notes ultimately received just pennies on the dollar.

Who are they for? ETNs can sometimes do a better job of tracking commodity prices than other kinds of exchange-traded products. If you're investing in a commodity ETN, opt for one with a wide range of investments and solid backing. For example, Elements Rogers International Commodity ETN (RJI) tracks 36 commodities and is backed by the Swedish government.

Obscure Country ETFs

What are they? These ETFs aim to sample the economy of a single, small country.

Why you don't need one: We can understand that you might want to add a smidgen of fast-growing China or a dollop of powerful Germany to your portfolio. But, seriously, do you really know enough about Qatar or the United Arab Emirates to justify an investment in iShares MSCI Qatar Capped ETF (QAT) or iShares MSCI UAE Capped ETF (UAE)? You might assume these funds represent a good way to get exposure to the oil-rich Middle East. But at last report, both funds were heavily positioned in financial stocks -- and each held less than 10% of its assets in energy.

Who they are for: Investors who know a country well and want to build their allocations in emerging markets.

Currency Hedged Overseas Sector ETFs

What are they? These ETFs track an index focused on a specific sector of a foreign economy and hedge to protect investors from fluctuating exchange rates.

Why you don't need one: WisdomTree offers a dozen currency-hedged international ETFs. These funds should perform better than unhedged foreign funds during periods when the U.S. dollar is strengthening. (When the buck gets brawnier, money held in foreign currencies gets translated into fewer dollars.)

Offering hedged overseas funds isn't, by itself, the worst idea in the world. But WisdomTree goes too far. Only two of its 12 ETFs are diversified among stocks in many foreign companies, and five of the ETFs focus on sectors in Japan -- for example, WisdomTree Japan Hedged Health Care (DXJH). To invest in this ETF, you're in effect making a bet on the country and the sector and assuming that the yen will weaken against the dollar. As tennis legend John McEnroe would say when he felt aggrieved by an official's call, "You can't be serious!"

Who are they for: We can't imagine.

Narrow Sector ETFs

What are they? Unlike funds that focus on broad sectors such as health, energy and technology, these ETFs zero in on narrow parts of the market.

Why you don't need one: These specialized ETFs are limited to a small field of potential investments and are too concentrated to sample the broader sector. In the race to pull in new cash, firms have launched some outlandish ETFs and waited to see what would take root. In 2007, XShares Advisors launched the HealthShares series of 19 niche ETFs, including a Dermatology & Wound Care fund and a Metabolic-Endocrine Disorders fund. By the end of 2008, the entire lineup was shuttered, largely due to a lack of investor interest. HealthShares is now out of business.

Still, there's no shortage of overly niched ETFs. Global X's Food Industry ETF lineup has been reduced to one member -- Global X Fertilizer/Potash ETF (SOIL), which mimics the performance of an index that invests in companies within the fertilizer industry. Unless you have enough dirt on a specific sector to plant your cash wisely, steer clear.

Who are they for? Investors who would rather buy a few similar stocks than just one.

Single Commodity ETFs

What are they? Most commodity ETFs invest in a group of things, such as agricultural goods, precious metals or natural resources. Some, however, invest only in one specific commodity.

Why you don't need one: Gold bugs will argue for the yellow metal until the cows come home. That's one reason why SPDR Gold Shares (GLD), which tracks the price of bullion, now holds more than $33 billion in assets. Want to invest in the cows themselves? You can do that with iPath Dow Jones-UBS Livestock Subindex (COW), an ETN that tracks an index of futures contracts for live cattle and lean hogs. Prefer crops over cows? An outfit called Teucrium offers ETFs for four farming staples: Teucrium Corn (CORN), Teucrium Wheat (WEAT), Teucrium Soybean (SOYB) and Teucrium Sugar (CANE). Not a sweet idea, in our view.

Who are they for? Remember the Duke brothers in the 1983 movie Trading Places? They were certain they knew which way the price of orange juice futures was heading. If you have as much conviction as they did, buy one of these funds. Just remember that in the end, the Dukes got their comeuppance.

Trend ETFs

What are they: These ETFs hitch their wagon to the latest craze, whether it's aiming to profit from Bitcoins or the legalization of marijuana.

Why you don't need one: Some trends are nothing more than a flash in the pan, while others develop into something important. When the first specialty Internet funds launched in the late 1990s, people were skeptical. But all things Web were hot, and most of the funds were successful until the tech bubble burst in 2000. Other trend-centric investments, such as Element's Credit Suisse Global Warming ETN, fold relatively quickly.

It's virtually impossible to pass judgment on a trend in its early stages. For example, a Bitcoin ETF, which would purchase the digital currency to back the ETF shares, is currently awaiting approval from the Securities and Exchange Commission. In some ways, a Bitcoin ETF isn't radically different than other currency ETFs: It offers investors exposure to the changing value of a currency without requiring them to buy the actual currency. But unlike, say, the euro or the yen, Bitcoin is an unregulated digital currency that, outside of a relatively small community, has yet to earn its stripes.

Who are they for? Risk-takers who think they can figure out how trends will play out.

Volatility ETFs

What are they? These ETFs aim to profit from other investors' fears by tracking an index that measures expected market volatility.

Why you don't need one: ProShares offers a series of volatility ETFs, including ProShares VIX Short-Term Futures (VIXY) and ProShares VIX Mid-Term Futures (VIXM). Both measure the expected volatility of the S&P 500. Over the past three years through August 13, the ETFs produced cumulative losses of 94.6% and 77.5%, respectively. Enough said.

Who are they for? No one.

Take care when choosing a housemate. For example, if you're a quiet neatnik who goes to bed early, you probably don't want a messy night owl who loves to party at home.

You should set specific house rules and put them in writing. The rules could cover such issues as smoking, overnight guests, pets and use of the common rooms. Meet in person unless the prospective home sharer lives far away--you could then use Skype or FaceTime. Check references, and make sure the person pays his or her share before moving in.

A variation on the home-sharing theme is "cohouseholding," where unrelated people, often friends, own or rent one house together. In 2010, Oz Ragland, a former Microsoft manager, and his wife bought a $680,000 house on 1.3 acres in Bothell, Wash., outside Seattle, with people they knew: another married couple and a single woman, then ages 54 to 71.

The housemates formed a limited liability corporation to own and operate the property. The residents pay rent to the LLC, which pays for taxes, utilities and maintenance. The five residents own different percentages of the LLC. Some cohouseholds choose instead to have all of the owners' names on the deed and mortgage. Hire a lawyer to work out the ownership details.

Co-owners need to decide what happens if one wants out. In the Ragland cohousehold, that person gives notice, and all the owners try to agree on how much money the departing member receives. If they can't agree, an appraisal sets the overall market price and that person receives his or her share--either immediately or over five years with interest.

One reason it works well: The house has a lot of private space for each couple or person. "I couldn't possibly own a house like this by myself--and with no mortgage," says Ragland, who is a founder of this cooperative housing movement. For details, go to the Web site of the Cohouseholding Project at www.cohouseholding.org.

Also on the horizon: friends living in the same building or next door but not under one roof. Within 10 to 15 years, Ruth Margolis, an Atlanta software industry analyst, and her husband, James, expect to rent in the same building or next door to a couple from North Carolina, as well as a couple and a divorced friend from Florida. These days, "we travel together, visit one another and are a bit miserable when we're not together. It's lovely to be planning for a time when we can all be together," Margolis says.

They have not chosen their destination city, but are considering several cities in the South. They all have long-term-care insurance, but if anyone needs professional care, "we will help each other with caregiving as we have in the past for other health-related issues," Margolis says.

VILLAGE PEOPLE

The "village" model provides a way to stay in your home while getting support from your neighbors. You can either join a membership organization in your geographic area or create your own village with neighbors.

Consider it one-stop shopping with a personal touch: You call a central number where paid staff or volunteers handle your requests. The staff could provide names of vetted and discounted service providers, such as home health care agencies or plumbers. Or, more often, it will arrange help from volunteers, such as someone to walk a dog, take a resident to a doctor or even change a light bulb.

The villages also create opportunities to socialize with other members, whether it's an organized dinner or a trip to the museum. Some larger villages arrange overseas travel. Yearly fees average $400 for an individual and $650 for a household.

There's an intergenerational benefit, too. The high school student down the street may provide computer tutoring to an older neighbor. A senior also could volunteer--perhaps a retired accountant could help with a neighbor's taxes. Older village members who volunteer or who receive help from volunteers are less likely to feel isolated.

Indeed, the villages' benefits extend beyond help with an errand or two. Andrew Scharlach, professor of aging at the School of Social Welfare at University of California, Berkeley, has conducted four surveys of villages. "There is preliminary evidence that members use the hospital less often than they did before they joined the village," he says. He also says that residents "report that they're more confident about their ability to age in place because of the membership."

Residents in the Beacon Hill neighborhood in Boston started the first village in 2002. Since then, 144 villages have opened nationwide, with another 115 in development in cities, suburbs and rural areas.

Nearly three years ago, Gloria Gordon, 91, a former psychologist and book editor, hatched the idea of starting a village with three friends in their St. Louis neighborhood. They bought a how-to manual put out by the Beacon Hill Village and visited a village in Chicago before launching STL Village in June, for residents 50 and older. It hired a part-time executive director.

Gordon lives in a high-rise, while some members are in single-family homes. Her children live in New York City and Boston. "Joining the village gives me a sense of support and security about the future," Gordon says. "It also lets my children feel okay about having a 90-year-old mom living independently a thousand miles away."

To find a village near you, or to start one, contact the Village-to-Village network (www.vtvnetwork.org). You could order a manual from the Beacon Hill Village (www.beaconhillvillage.org).

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Kaitlin Pitsker is a reporter at Kiplinger's Personal Finance.

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