Photo: Russell Neches, Flickr.
It's smart to consider investing in exchange-traded funds (ETFs), because these stock-like funds offer instant diversification, convenient trading throughout the day, no minimum purchase amounts, and fees that are typically lower than their mutual-fund cousins. You'll naturally want to avoid the worst ETFs -- but don't get sidetracked looking for the ETFs that performed the worst over the past year or any particular period. Instead, learn how to spot a bad ETF and the worst kinds of ETFs.
Here are some things to watch out for when investing in ETFs:
Fees
Just like mutual funds do, ETFs charge expense ratios -- essentially annual fees. But while stock mutual funds sport average expense ratios near 1.3%, the average ETF expense ratio is far lower, closer to 0.40%. Still, steep fees can be found among ETFs, and they can help you identify some of the worst ETFs for 2016 and beyond.
The WBI Tactical Value ETF (WBIF), for example, recently charged 1.04%. Interestingly, the fund recently held two-thirds of its assets in cash, meaning that its shareholders are paying a lot to not be invested in many stocks.
Size
Many ETFs, especially new and small ones, sport wide "spreads," which can be costly to investors. The spread is the difference between the "bid" and the "ask" -- respectively, the going price at which you can buy and sell a security. When a stock, or an ETF, is very "liquid," the spread will be tiny, reflecting the fact that there are lots of shares available and that they're trading frequently on the market. With less liquid investments, fewer people are interested in them and they trade less frequently. Thus, a seller is more able to hold out for a higher price.
When it's relatively hard to sell your shares of an ETF, it can cost you. The Market Vectors Egypt ETF (EGPT +0.00%), for example, recently sported a spread of 1.3%, reflecting the low trading volume of the ETF and the difficulty of buying and selling shares of the underlying securities held by the fund.
Beware of lemons when investing. Image: Pixabay.
Leverage
Some ETFs are structured in ways that aim for extra growth but offer extra risk and danger, too. A prime example are ETFs that are leveraged and labeled "inverse," "ultra," "2X," "3X," or something like that. A rookie mistake is thinking that since an ETF such as the ProShares Ultra Dow 30 ETF (DDM +2.60%) is designed to deliver a return that's twice as good (or bad) as the Dow's return, one might invest in it for a long time, aiming to get outsized returns. The truth is that these highly leveraged funds are designed to be held for short periods and can deliver ruinous results over long periods. No wonder my colleague Travis Hoium has deemed these "the riskiest investments on Earth." Leveraged ETFs (those that employ significant debt) are best avoided by most of us.
Focus
Just because an ETF gives you instant access to some industry or niche of interest doesn't mean it will serve you well, especially in the short term. The United States Oil Fund, for example, got whacked when oil prices dropped -- the ETF lost more than 40% in both 2014 and 2015. Meanwhile, the Market Vectors Brazil Small-Cap ETF shed nearly 50% in 2015 (on top of a 26% loss in 2014). That's no guarantee they'll perform badly in 2016 and beyond, but it does highlight the dangers of taking what had been hot areas of the market in previous years and assuming that those returns will last forever.
ETFs can be a wonderful and inexpensive way to tap the advantages of funds, but choose carefully. If you pay attention to the fees charged by any fund you're looking at, and consider its spread, leverage, and focus, you will be much more likely to avoid stumbling into the ETFs that end up among 2016's poorest performers. You'll make smarter ETF decisions for the rest of your investing life, too.
