The Right Way to Use ETFs

One of the hottest investing trends of the past five years has been the explosion in exchange-traded funds. Yet although many have taken advantages of ETFs simply to jump onto the latest short-term trends, smart investors use ETFs as just another helpful tool in their overall investing arsenal.

How ETFs can lose you money
The primary appeal of ETFs is their tradability. It's easy to use ETFs to make bets on markets, market sectors, or even individual investments. Moreover, because you can buy and sell ETFs anytime the stock market is open, trading them early and often is not only possible but tempting for many.

But that appeal has also led many investors to lose money with ETFs. Consider the following:

  • ETFs linked to the futures markets can make terrible long-term investments. United States Natural Gas (NYSE: UNG  ) has lost 85% of its value in the past four years because of the way natural gas futures are priced.
  • Leveraged ETFs work well for day traders, but over the long run, you can get burned even when you're right about which way the market you're tracking moves. For instance, both the bullish ProShares Ultra Oil & Gas (NYSE: DIG  ) and the bearish ProShares UltraShort Oil & Gas (NYSE: DUG  ) have lost money over the past four years.

Perhaps the most dangerous part of ETFs is that they're often designed to ride the coattails of the most popular new stocks. For instance, the brand-new leveraged Internet IPO ETN from UBS offers returns linked to an index of newly public tech stocks, including Pandora (NYSE: P  ) , Renren (NYSE: RENN  ) , and Ancestry.com (Nasdaq: ACOM  ) . Rather than providing a stabilizing counterbalance to the near-hysteria over recent IPOs, UBS is banking on their interest to drive sales of its ETN products.

The better way to play
Just because others use ETFs unwisely doesn't mean that you have to follow their lead. Fortunately, you can find great uses for ETFs in your long-term investing portfolio.

The most obvious way to include ETFs in your investing strategy is to take advantage of their low costs and tax efficiency by buying broad-market index-targeted ETFs. With just a handful of funds, you can build a simple, cheap core portfolio that doesn't require a lot of attention. And with several brokerage companies now offering broad-market ETFs without charging their customers any commissions to buy or sell them, it's less expensive than ever to turn to ETFs for your primary investing.

Another strong ETF choice is to pick niche areas of the market that you'd have trouble investing in outside an ETF. For instance, bullion ETFs like iShares Silver Trust (NYSE: SLV  ) have been so popular because they fill a void in the investing world. Buying physical silver often involves paying huge premiums from dealers, but in ETF form, you can get assurances that your fund owns actual bullion while getting the advantages of being in an investment pool with thousands of other shareholders.

Finally, ETFs offer some useful tactical opportunities. For instance, as the end of the year approaches, you may want to take advantage of tax losses on stocks you own that have gone down. But to do so, you can't buy back shares you sell for 30 days. Many fear that during that time period, they'll miss out on a rebound.

But you can protect yourself against at least one part of that risk by buying a related ETF. For instance, if you sold a losing telecom stock, you could buy a telecom ETF that includes that stock along with other industry rivals. If the whole industry rebounds, then your ETF should provide you with gains. Sure, if a company-specific news item boosts only your stock, the ETF might not give you full compensation -- but you'll at least get part of your gains.

Be smart with ETFs
So don't let the hype surrounding ETFs lure you into using them for the wrong reasons. Given how useful ETFs can be when you use them correctly, you don't need to get caught up in bad strategies that will just end up costing you money.

Find out about good ETFs that have great promise for delivering profits to shareholders. The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery," will show you the right way.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger likes to keep things simple. He owns shares of iShares Silver Trust. Motley Fool newsletter services have recommended buying shares of Ancestry.com. 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 points you in the right direction.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 25, 2011, at 4:55 PM, investigateinv wrote:

    That is an understatement about leveraged ETFs. Getting burned over the "long run" should be defined as more than one day. Even in a flat but volatile market these things can lose significant value.

    www.investigateinv.com

  • Report this Comment On August 01, 2011, at 12:51 PM, bujohnso wrote:

    Including <a href="https://www.lincolntrustco.com/401(k)/Pages/ETFs.aspx"&... in 401(k) plans</a>can be a great way to lower the “all in” cost of a retirement plan for your participants. Any open architecture provider should be able to offer access to hundreds of ETFs from numerous fund families.

  • Report this Comment On August 24, 2011, at 7:02 AM, hot1053 wrote:

    Guys, ETFs are generally not safe. Follow them on CAPS, but for most people, there are too many factors that bring risk.

    Read the following article:

    http://seekingalpha.com/article/141517-why-etfs-are-a-scam

    Regarding SLV:

    I've got news for you. There is no assurance the SLV has the bullion!

    Read into their prospectus. They are not responsible for missing or stolen bullion!

    Does anyone know who has one of the largest net short positions in silver?

    Chase.

    Whose the custodian in charge of holding the bullion?

    You know it.

    Chase!

    Guys it's not impossible, Chase could lease out the silver to claim it's saving storage costs, earning interest on the lease, etc. and we wouldn't know about it until it's too late.

    The problem is there's a huge conflict of interest becuase Chase is losing huge in Silver right now and if (and probably when) it gets it's margin call, don't be surprised if you see that the leased Silver is kept and SLV's vaults are not holding what they promise.

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