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If you're an experienced investor, you know that following the crowd can get you into trouble. Even among the relatively new universe of exchange-traded funds, that lesson holds true in a big way. Before you jump into the next hot ETF investment, make sure you're not buying into a fad that's likely to burn out in the months and years to come.
Why ETFs are hot
ETFs are extremely useful investment tools. They give you access to an almost unlimited variety of ways to invest. Want to focus on big, small, or medium-sized companies? Various ETFs will give you exposure to any particular size you like. Interested in a particular industry? Sector ETFs let you slice and dice the stock market to grab companies in the most promising lines of business. And if you're interested in going beyond the obvious stocks to newer types of investment vehicles, then the odds are good that you'll first be able to invest in them through an ETF.
One interesting thing about ETFs is that because they haven't been around as long as stocks and traditional mutual funds, there's still plenty of innovation going on in the ETF universe. You won't find many new ideas among the thousands of mutual funds already out there, but ETF providers are always trying to find the next profitable niche to grab investor attention. That not only gives investors new ways to try to earn great returns, but also gives you a chance to observe the behavior of the ETF crowd and analyze whether it pays to follow it or to steer clear.
A history of bad calls
As it turns out, investors who jump on the latest ETF fad have an uncanny tendency to identify fads that are destined to burn out shortly thereafter. An article in Barron's over the weekend used Morningstar data to ferret out which ETFs were the most popular over the past several years. It then looked at the returns on those popular ETFs over the following 12 months.
What it found was that at least in the recent past, ETF investors have done well at choosing future losers. Here's the rundown:
- In 2007, the Vanguard FTSE All-World ex-US ETF (NYSE: VEU ) pulled in the most assets of any new ETF. The following year, it finished in the middle of its peer group -- with a 44% loss.
- 2008 brought an interest in betting against the multidecade bull market in bonds, and the ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT ) took first place for raising new assets. It lost nearly half its value by the end of 2008, and despite a good 2009, the ETF shares are now worth only a bit more than they were when 2008 ended.
- The following year, investors wanted a way to profit directly from volatility, and the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX ) was born. Since early 2009, that fund has lost over 90% of its value, as ongoing structural problems have helped cause its value to deteriorate steadily from month to month.
How does that bode for 2010? The Barron's article doesn't specify exactly which ETF won the prize for most assets gathered last year, but it mentions that two top contenders are physical platinum and palladium ETFs. Those are mostly likely ETFS Physical Platinum (NYSE: PPLT ) and ETFS Physical Palladium (NYSE: PALL ) , with a combined $1.6 billion in assets under management after debuting this time last year.
The smarter move
Obviously, not all brand-new ETFs have turned out to be terrible investments. In previous years, innovations like Vanguard Emerging Markets Stock (NYSE: VWO ) and PowerShares DB Commodity Index Tracking (NYSE: DBC ) have helped investors diversify their portfolios in ways they really couldn't before. And at least in the case of emerging markets, those moves have enhanced long-term returns.
But in general, the latest fads aren't the right place to put a big chunk of your money. Sticking with established ETFs for the bulk of your money will do a much better job of protecting your portfolio while also giving you the chance to improve your returns.
Get the right ETFs for a winning portfolio. Read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."
Fool contributor Dan Caplinger has been known to forget when his woodstove is hot and appreciates the gloves he got as a Christmas gift. He owns shares of Vanguard Emerging Markets Stock ETF. The Fool has written naked calls on the iPath S&P 500 VIX Short-Term Futures ETN and also owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy makes us all feel warm inside.