Overestimating Your Sophistication

Mutual funds are still the primary investment vehicle used by retail investors, but exchange-traded funds have dramatically changed the landscape. Many investors have chosen some exotic ETFs because many noncore mutual funds have a number of restrictions that limit their availability to the average investor. For instance, some mutual funds impose investment minimums and have different share classes that charge varying fees based on how large your investment is. Moreover, the menu of available funds could vary depending on which brokerage an investor transacts through. Even higher hurdles exist with hedge funds and managed futures strategies, which are available only to accredited investors with a net worth greater than $1 million.

Many of those barriers no longer exist; ETFs have democratized investing by making several previously inaccessible asset classes available to the masses. One of the simple and best examples of this is gold. Through  SPDR Gold Shares (GLD), any investor can own shares in physical gold bars held in a bank vault in London, which rids investors of the inefficiencies and inconveniences associated with transporting and storing gold.

Of course, this enhanced flexibility comes with the downside of increased complexity. In some ETFs you'll find futures, forwards, swaps, foreign currency, and physical commodities. While most people understand how stocks and bonds fit into their portfolio, the implications of owning exotic derivatives are beyond the scope of most individual investors. And because there are no disclaimers that read, "You must be this tall to ride," it is critical that investors engage in sufficient self-assessment before venturing into products that may be beyond their comfort zone.

Today anyone with a brokerage account can invest in Russian rubles, South Korean small caps, cocoa, carbon credits, and short Latin American stocks with 300% leverage. While these funds might have their particular uses, they certainly do not belong in the average investor's portfolio. But because these funds are just as easy to purchase as your typical S&P 500 ETF, it can be tempting to add them. These sexier funds can be more interesting and fun to speculate on, but many investors get burned due to some dangerous misconceptions or a lack of complete understanding. Let's review some problematic situations.

Rolling Backwards
Thanks to market liquidity and the absence of carrying costs, using futures is, in many aspects, a better way to invest in commodities than owning them directly. However the strategy does have some major flaws. For example, if you have a bullish opinion on natural gas it is not practical to buy actual natural gas. Where would you store it and at what cost? Buying natural gas futures gives you exposure to price changes in natural gas but not direct exposure to the spot price. This is a key difference because the returns of a portfolio invested in futures contracts can deviate wildly from the returns of the spot price.

This is because futures contracts expire and need to be rolled to the next month. When the market is in contango, like it has been for the past few years, you lose money every month that the contract is rolled. A startling example of this is the returns for  United States Natural Gas (UNG). In 2009, the spot price of natural gas was up 3.37%, and the return of UNG was a negative 56.50%. At the end of 2009, UNG had $4.5 billion in assets, and I assume many of those investors thought they were getting the spot natural gas price and were sorely disappointed.

Compounding the Misery
Leveraged ETFs have received have received a great deal of press in the past few years--mostly for the disastrous effects they can have if held for an extended period. A majority of leveraged ETFs reset their leverage on a daily basis, which greatly increases volatility and produces substantial volatility drag on performance relative to the benchmark over time. For example, the financial sector represented by  Financial Select Sector SPDR (XLF) is down 5.5% in the past year. If you decided to bet against financial stocks using the  Direxion Daily Financial Bear 3x (FAZ) you might have expected to earn a return of more than 15% minus fees. Instead, because of the volatility drag created by the daily resetting of leverage, you would have actually lost 27.2%. This is one of the most painful investor experiences: correct thesis, wrong execution.

Jumping on the Bandwagon
ETF creators love to launch niche ETFs focusing on a popular trend. Alternative energy is one of those ideas; it's a concept that most people understand at a primitive level and want to succeed. It seems that if you could just invest now before it really takes off it would be a great long-term investment. Oh, if only investing were so simple.

Investors need to look beyond the name of the fund and look inside at the holdings to make sure they're getting the exposure they want.  Global X Lithium ETF (LIT) was recently launched and is marketed as a way to gain access to the growing lithium market. Lithium is used in rechargeable batteries, and there is hope that as more electric cars get produced there will be massive demand for lithium. When you look at the holdings of the ETF, the top three holdings are all chemical companies that comprise 50% of the fund. These companies are active in the lithium market but receive a small percentage of their earnings from their lithium divisions. ETFs must stick to publicly traded securities, and sometimes there is no good way to invest in certain investment themes in the public markets. In this case, the nomenclature of the fund is vastly different from the fundamentals that will drive the eventual outcome.

Exotic Travels
Another growing trend is issuance of international ETFs investing in unique foreign markets. There are more than 60 ETFs that invest only in stocks of a single foreign country. The flexibility to tailor your international exposure to individual countries allows for great customization but increases risks dramatically.

IShares MSCI Turkey Investable Market (TUR) gives investors access to a basket of ADRs representing the investable Turkish market. An investment in TUR could be enticing because Turkey has had very strong GDP growth over the past few years and is a potential new member of the European Union. With its central location, Turkey is the gateway between Europe and the Middle East. It could be the emerging-markets growth story of the next decade like Brazil was for the past 10 years. It also could completely collapse. Since 1960, there have been four military coups and in February 2010 there was an attempted military coup that ultimately failed but roiled the Turkish market for a few days. I doubt that most U.S. investors understand the political and economic realities of Turkey enough to make a concentrated investment in TUR.

The Good News
The ETF structure brings retail and institutional investors together in the same vehicle. This has many advantages, such as increased liquidity and low fees, but sometimes investors can get caught in investments that are unsuitable for their situation. If investors stick to the many ETFs that track well known indexes and offer low fees, ETFs can be a great investment option for just about anyone.

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