In the investing environment that we live in today, many long-term investors look towards Exchange Traded Funds (ETFs) as an easy and cheap way to stay invested in the market over the long run.
There is a huge variety of investable ETFs available today, each structured more creatively than its predecessors. However, investors would benefit from understanding what exactly they are investing in, which can be very different from what the name of the ETF suggests.
From the perspective of the average long-term buy-and-hold investor, it might be wise to steer clear of these couple of ETFs, which are much better suited for shorter-term trading.
#1: Leveraged ETFs
These are ETFs that offer 2x or even higher leverage on whatever you are looking to invest in, from gold to stock indices. On first impression for a 2x ETF, investors may think that they are simply doubling their exposure, with all gains and losses being amplified by exactly 2x.
However, the actual returns the investor receives could vary very significantly from the above expectation. And it is because of this reason that long-term holders need to be very careful with these ETFs.
The simplified explanation is that these ETFs do not offer a 1-to-1-price relationship with the underlying asset, due to the leverage being offered and the ETF having to be adjusted on a daily basis. For example a 2x ETF on gold would seek to replicate double the return on a daily basis. The return will deviate substantially over longer periods of time. Your annual return would deviate significantly from what you expect (usually for the worse).
The worst environment to be holding such ETFs long-term is during a volatile range-bound market. This would cause the ETF price to “decay”, even if the underlying indexes price is still pretty much around the same level.
#2: Futures-Based ETFs
Another type of ETF that is usually bad for long-term portfolios is the ETF that requires exposure to futures contracts in order to track the underlying index. Examples would be ETFs that provide exposure to volatility (VIX) and commodities (like oil).
The simple explanation is that these assets do not trade like stocks (indefinite basis except in case of delisting), and their prices are dependent on futures contracts that have fixed expiry dates. To construct an ETF that replicates the price long-term would require selling old contracts and buying new ones at fixed intervals. Due to market conditions, the price between the old and new contracts could be huge, and the ETF price will reflect this.
The negative impact on the ETF occurs when the futures markets are in contango, meaning the new contracts are more expensive than the old ones and you are paying a premium to simply carry your exposure forward.
Beyond theory, one has to look at long-term charts of ETFs like UNG (natural gas) to see how holding it in the long-term would be a disaster. On top of the price and volatility risk you are already adding to your portfolio, you will also be subjecting yourself to huge tracking error – meaning you are not getting the long-term exposure you initially wanted.
In conclusion, while we believe ETFs are a great tool for retail investors to be able to gain different kind of exposure in the investing world, it is worth remembering as well that not all ETFs work the same way, or are exposed to the same risks.
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