I’ve always praised ETFs to you as something unsurpassed and really cool. Well there are Foolish ETFs to prove me wrong.
ETFs are brilliant tools for the long run: low costs, diversification and simplicity.
Unfortunately, there are ETFs that you shouldn’t invest in. Now I’ll tell you which ones.
All the following categories are not physically replicated and contain derivatives in their structure, so they are exposed to counterparty and other risks.
Commodity (Foolish) ETFs
Commodity ETFs invest in futures contracts. If you don’t know what futures are, it’s because I never said so. Bad! You should study yourself too. Futures promise to buy (or sell) physical commodities, such as oil, gold, copper, wheat, etc. on a later specified date.
- Fees tend to be high, sometimes as high as 0.50% to 1.00% per annum. We have always said that fees are important.
- To retire we need passive income. Stocks generate passive income because you own a share of the economy’s productive capital. Raw materials are dead things that do not multiply.
Spot commodity prices roughly track CPI inflation over the long term, so real yields before fees should be around zero. After the commissions, you lose money in real terms.
- Contango effect. Futures prices are above the spot price, the more the futures expiry is in the future. Because the futures price must move closer to the spot price over time, you continually lose money by selling existing futures contracts close to the spot price and buying more expensive contracts with a later expiration date. (If you don’t understand everything there is a link that explains it).
(Foolish) ETF VIX
The VIX is a real-time volatility index created by the Chicago Board Options Exchange (CBOE). This is the first index capable of quantifying expectations on market volatility. Retroactive analysis is not possible with the VIX, as it only shows the implied volatility of the S&P 500 (SPX) over the next 30 days.
Sounds like a great idea: if the market goes down, the volatility index (VIX) goes up. Excellent downside protection, why not buy it?
Same reasons as above:
High commissions, no passive income and contango effect. This is also accentuated. During normal market conditions, the VIX is typically below 20. When the VIX is below 20, it’s common for contango to be present in the VIX futures market. Why? because it is easy that in the future the market will have a crash. We don’t know when, but it would be.
(Foolish) Levered ETFs
The problem with these tools is that they have very high fees. The more volatility there is, the greater the bias with respect to its index. More volatility means the leveraged ETN will lose money faster.
Suppose, for example, that we have a leveraged ETF 2 on the S&P 500: the index and the ETF both start at a value of 100. The next day, the index shows a 5% rise, going from 100 to 105, resulting in an appreciation of the 10% of leveraged ETF 2 whose value grows from 100 to 110. The following day the S&P 500 slips by 10%, whose value therefore falls to 94.5 (105 – 10.5), generating a daily loss by 20% for leveraged ETF 2 whose value drops to 88 (110 – 22). As you can see at the end the value is lower.
Otherwise you would not have earned double but the price would have been “only” 108. Instead of 104.5.
S&P500: 100–>110 (+10%)–>104.5(-5%)
ETFs x2: 100–>120 (+20%)–>108(-10%)
A x2 leveraged ETF has more than double the losses and less than double the gains. Not very smart.
Apart from that, leverage means more risk. We don’t need more risk on the money we will use in retirement.
In the case of leveraged commodities, the cons of both the above categories must be applied.