Nearly every decade, a new financial craze sweeps the markets. In the 1980s, junk bonds captured high yields at a time of rapidly-falling interest rates. In the 1990s, investors moved into high-fee mutual funds, which offered a one-stop-shop for diversification.
Over the past decade, two new investment products came to the forefront. The first, collateralized debt obligations (CDOs) blew up spectacularly in 2008. These assets, mortgages in the “it never goes down!” housing market, became increasingly backed by pools of mortgages funded without stringent underwriting standards.
The second product, the exchange traded fund (ETF) has continued to surge with popularity among investors. That’s because ETFs offer the same type of diversification as mutual funds, but often at a fraction of the fees.
But all is not well with these products—and investors should be wary.
The biggest problem facing ETF investors today is having too many choices. In the past decade, ETF issuance has greatly surged from 113 ETFs in 2002 to 1,440 in 2012. This 10-fold level of growth isn’t sustainable.
Today, investors can find an ETF with a laser-like focus on a specific sector. They can find ETFs that leverage up that sector’s performance by 2 or 3 times—either on the long side, or the short side.
More importantly, ETFs have already become the most popular investment vehicle today. If ETF growth doesn’t significantly slow over the next few years, it may signal that it’s time to invest elsewhere until the excesses are weeded out.
Investors should always beware new financial products until they’ve had a chance to be proven during a period of market stress. For traditional ETFs, that moment came with the financial crisis. Unleveraged funds performed in line with the overall markets.
But the returns of leveraged ETFs have in many cases failed to perform as they should have. For instance, a double-leveraged ETF that should surge 10% when its tracking index falls 5% won’t necessarily see that kind of return.
Why? For starters, it’s because leveraged ETFs use options. Options impose both an intrinsic value and a time premium on the buyer. As the option moves closer to expiration, the time premium evaporates. As leveraged ETFs “roll” the options by selling soon-to-expire options for ones further out, they have to pay out time premium.
This unfortunate drag means that leveraged ETFs are a poor long-term investment vehicle. Over the short-term, they may perform better than expected, but timing is everything.
Unleveraged, broad-index ETFs should provide investors the opportunity for diversification without the problems associated with their leveraged counterparts.
Investors must nevertheless remain vigilant for any substantial market changes and be willing to act accordingly. Don’t rely on increased leverage to “make up” for lost investment power. Only use leveraged funds when the markets are at extreme points. We’re not there yet.
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