Avoid These ETFs

This month, Morningstar launched its newest monthly publication--Morningstar ETFInvestor. In the following article, Sonya Morris, the newsletter's editor, analyzes some of the newest specialized exchange-traded funds. For more on Morningstar ETFInvestor, clickhere. With your first issue, you'll receive three free reports: The ABCs of ETFs, Choosing ETFs the Morningstar ETFInvestor Way, and The ETF Numbers that Matter--and Why.

With most of the equity universe covered two and sometimes three times over by broad-based exchange-traded funds, ETF providers have had to become more creative to distinguish their newest offerings from what's already on the market. But many of these newfangled ETFs stray from the original aims of indexing and traffic in risky market segments that most individual investors are better off avoiding.

Single-Commodity ETFs
Perhaps the most obvious examples of ETFs that no one needs are those that offer exposure to a single commodity or a small basket of commodities. Commodity funds started out admirably enough. The oldest offerings in the group provide investors exposure to a wide range of commodities and, thus, have the potential to add valuable diversification to a portfolio. But ETF providers have begun to offer funds that focus on narrower niches of the commodity market. While one might make an investment case for dedicating a small portion of assets to a gold ETF as a diversifier or an inflation hedge, it's difficult to see the investment merit of other pure-play commodity ETFs.

Given the media fervor surrounding the price of oil, it's not surprising that one of the first single-commodity ETFs focused on that market segment. United States Oil (USO), which provides exposure to West Texas Intermediate Light Sweet Crude, was the first pure-play oil ETF launched. And it's proved popular with investors, growing to more than $400 million in assets since its April 2006 debut.

Not to be left out of such a popular niche, Barclays recently introduced iPath Goldman Sachs Crude Oil , an exchange-traded note that provides exposure to crude. (For more on ETNs, see my colleague Dan Culloton's article).

And Barclay's isn't stopping with oil, either. It has filed with the SEC to offer ETFs that provide exposure to other commodities, including industrial metals and livestock. Deutsche Bank also has a slate of commodity ETFs awaiting SEC approval, including an oil ETF, a base metals ETF, and an agriculture ETF, which provides exposure to corn, soybeans, sugar, and wheat.

I think these pure-play commodity ETFs have little to offer the long-term investor and are primarily aimed at speculators interested in making short-term bets on the direction of capricious commodity prices. That's a perilous game to play and one that very few investors can pull off successfully with any consistency.

What's more, these niche ETFs court volatility. In fact, US Oil shareholders just got an unpleasant reminder that oil prices don't always go up. The fund has plunged more than 10% in just the last month as the price of oil slid off its highs.

It's also worth noting that commodity funds don't have the same tax benefits as other funds. Rather than tracking an index composed of stocks, many of these ETFs gain commodity exposure through derivative securities such as futures, and 40% of the gains on futures contracts are taxed at higher short-term rates (equivalent to the taxpayer's ordinary income-tax rates). And gold and silver ETFs are taxed not as securities, but as collectibles, which means long-term capital gains on the funds are taxed at the maximum rate of 28% rather than the lower 15% rate you'd pay on stocks. Furthermore, instead of being organized as registered investment corporations, as mutual funds and most ETFs are, US Oil is structured as a partnership and the iShares funds are organized as limited liability companies. Under both structures, shareholders must pay taxes each year on the gains and income earned by the funds, even if they are not distributed. That means you could wind up owing taxes on income you never received.

Don't get me wrong. Commodities have characteristics that can make them useful portfolio diversifiers. (For more on how to use commodities in your portfolio, click here.) But to benefit from those traits, you must keep a long-term view. And you're better off investing in a fund or ETF that provides exposure to a broad basket of commodities, such as iPath Dow Jones-AIG Commodity Index (DJP) or PIMCO CommodityRealReturn .

Currency ETFs
Over the past year, a handful of ETFs have come out that offer exposure to selected currencies. Most recently, Rydex launched a slew of ETFs under the CurrencyShares banner that offer exposure to a variety of currencies around the globe, such as the Australian dollar and Swedish krona. Rydex was the first ETF provider to introduce a currency ETF, when it debuted the Euro Currency Trust (FXE) in December 2005.

Very few individuals have reason to own these funds. Making successful bets on currencies requires knowledge of global economic factors and deft forecasting. Even if you possess such skills, currency movements have an annoying tendency to defy the economic odds. For example, given the U.S.' burgeoning trade and budget deficits, most economists predicted a weakening dollar in 2005, yet the greenback flouted that consensus and strengthened against most major currencies that year. That's why most foreign mutual fund managers avoid currency wagers--they are notoriously hard to get right. Plus, they add extra trading costs that erode returns.

What's more, currency ETFs aren't as tax-efficient as other ETFs because interest income and gains and losses on currency are all taxed at ordinary income-tax rates rather than at lower long-term capital gains rates.

While it's important to have some nondollar exposure in your portfolio, that can be done more effectively--and with far less risk--by owning foreign stock and bond mutual funds that leave the bulk of their currency exposure unhedged.

Leveraged ETFs
Last week saw the largest ETF filing ever, when ProFunds sought approval from the SEC to offer 66 new ETFs under the ProShares label. All of these new ETFs will use some form of leverage. While it may take those funds a few months to get through the approval process, there are already a handful of leveraged ETFs on the market.

By way of background, a leveraged fund employs derivative securities to magnify its exposure to its chosen market segment. For example, ProShares Ultra S&P 500 (SSO) aims to double the returns of the S&P 500. So, if the S&P 500 gains 5%, the ETF should go up 10%. But keep in mind that the opposite is also true. If the S&P drops 5%, this ETF would drop 10%.

ProFunds also offers ETFs that provide inverse exposure to an index. For example, ProShares UltraShort S&P 500 (SDS) aims to deliver twice the inverse exposure to its benchmark. In other words, it should gain 10% if the S&P falls 5%.

These funds' managers use a combination of shorts, options, and futures to carry out the ETFs' stated goals. But there are a lot of moving parts to these strategies, and there's no guarantee that they will achieve their objectives. In fact, some of ProFunds conventional funds have fallen significantly short of their goals. Rather than doubling its benchmark's performance,  ProFunds UltraBull's (ULPIX) (the conventional counterpart to ProShares UltraShort S&P 500) five-year trailing returns actually trail the S&P 500's returns. That's partly because the fund's losses during the bear market were more than twice that of its benchmark and, because of the effects of compounding, those losses have a significant impact on long-term returns. The fund's performance has also been eroded by a high fee structure and the high trading costs of the strategy. Furthermore, while this fund hasn't succeeded in doubling its benchmark's return, it has succeeded in doubling its volatility. Its standard deviation of returns (a statistical measure of volatility) is twice that of the index's. Indeed, the fund's downside can be excruciating: 2002 was bad enough when the S&P dropped 22.2%, but this fund plunged 46.2% that year. Few investors possess the ironclad stomach necessary to endure such setbacks, and most would do well to steer clear of leveraged offerings altogether.

In sum, the ETF marketplace is growing by leaps and bounds and more specialized funds are sure to come to market. While it might be easy to get swept up in the buzz surrounding the newest offering, that's the time to be especially diligent and skeptical. Make sure you know what you're getting into before you take a leap into the newest new thing.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.