For investors seeking low-cost ways to invest, exchange-traded funds have been just about the perfect investment. Combining exposure to a wide variety of different types of investments with ease of purchase and a usually low-expense structure, ETFs have thrown the well-entrenched managed mutual fund industry into chaos as billions of dollars move out of mutual funds and into ETFs week after week.
But with thousands of different ETFs to choose from, which ones should you really be paying attention to in 2013? The following five ETFs aren't good investments -- they're too dangerous for most investors to dabble in -- but keeping an eye on them will nevertheless give you some valuable insight into the broader market.
1. iPath S&P 500 VIX Short-Term ETN (NYSEMKT: VXX )
Volatility was a major theme in 2012, and it will continue to be an important consideration in 2013. What was most surprising about 2012 was the lack of volatility in the stock market, as investors largely shrugged off concerns about the slow U.S. recovery, the European financial crisis, and the slowdown in emerging-market economies like China to push stocks to healthy gains for the year. Those who bought the iPath ETN expecting those problem points to evolve into major market crashes were sorely disappointed, as shares lost three-quarters of their value.
Assuming that markets will be equally stable in 2013 is a dangerous move, and so many investors will likely look to the iPath ETN as a potential moneymaker. But with futures contracts already pricing in rising volatility throughout the year, you'll have to see extraordinary uncertainty in order to book gains from the fund. Volatility-based investments definitely aren't for the meek, and most investors should stay away from this exchange-traded product.
2. United States Natural Gas ETF (NYSEMKT: UNG )
One market that did see extensive volatility was natural gas, which fell to decade lows before rebounding sharply. The United States Natural Gas ETF tracks gas prices using futures contracts, and it suffered losses overall but has risen more than 35% from its spring lows.
The disappointing thing, though, is that those 35% gains come despite the fact that spot gas prices have nearly doubled over the same time frame. Like the iPath volatility ETN, this nat-gas ETF's futures-based strategy doesn't allow it to track the spot price of natural gas. Because of that, the ETF has been a terrible long-term investment for those seeking to profit from natural gas, and with the market continuing not to cooperate, it doesn't look like the ETF will solve its underperformance problems in 2013 either.
3. Direxion Daily Gold Miners Bull 3x (NYSEMKT: NUGT )
Gold didn't live up to bulls' expectations in 2012, and gold mining stocks in particular got hit hard. With rising costs of production and a pause in the long bull market in gold and silver bullion, mining stocks took a double hit that led to significant declines. For the Direxion ETF, its triple-levered approach cost investors half their money this year.
Unfortunately, investors who chose the corresponding bearish 3x mining ETF also suffered losses. That's just another example of a long-understood phenomenon whereby in volatile markets, both members of opposing pairs of leveraged ETFs can fail to produce profits.
Nevertheless, this ETF is a good way to keep an eye on activity in the gold market. Investors just need to remember that these ETFs are better short-term trades than long-term investments.
4. ALPS Alerian MLP ETF (NYSEMKT: AMLP )
Master limited partnerships have inspired investors with their huge income distributions. But with the complications of MLPs for tax-reporting purposes, many investors have looked to ETFs like ALPS Alerian to avoid the hassle of partnership tax return requirements that MLPs impose on investors.
What many don't realize, though, is that ALPS Alerian is structured as a corporation rather than a pass-through registered investment company. As a result, it has to pay corporate tax on profits, meaning that investors take a 37.5% hit on profits due to the ETF's tax reserve policies. Given the massive gains in MLPs, those taxes have taken a huge bite out of investors' returns and represent too high a price for most to pay for tax simplicity. Yet following the ETF will keep you in touch with conditions in the MLP market.
5. Direxion Financial Bull 3x (NYSEMKT: FAS )
Banks and other financial institutions have soared in 2012, and the Direxion Financial Bull ETF has shared in those gains. Even the headwinds that leveraged ETFs face haven't held the ETF back from gaining around 80% in 2012.
In this case, the ETF did roughly what one would've wanted it to do, as an unleveraged ETF tracking the financial sector gained between 25% and 30%. As a way of gauging the health of bank stocks, the Direxion ETF is a reasonable choice for a watchlist, but in the long run, it too shares the shortcomings of its leveraged brethren.
All five of these ETFs are worth keeping a close eye on. But for most investors, there's no reason to add them to your real-money portfolio, as their risks have historically far outweighed their rewards and look likely to continue to do so in the future.
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