ETFs: Where the “fruitcakes, nutcases and lunatic fringe” can be found

Exchange Traded Funds (ETFs) can be a great tool for individual investors. Unfortunately we can’t say that they categorically are good for investors because ETFs now come is so many varieties, shapes and sizes.  This is a minefield of risk for the do-it-yourself investor.

ETFs can provide very low cost access to a broadly and globally diversified market portfolio that is appropriate for a long time horizon – good for investors.  The challenge is that with the proliferation of the number of different ETF products, investors have too many choices, many of which actually can be harmful.  According to the Canadian ETF association at the end of March 2016 there were 533 different ETFs listed in Canada – in the US there were 1,659.

You see the ETF is just a wrapper that can contain anything the ETF provider decides that is marketable.  That could mean a very diversified group of securities spanning a whole region of the world or a very narrow group of stocks focusing on a particular industry in a particular country.  How about the HealthShaers Dermatology and Wound Care ETF?  It didn’t last long.  Or the Direxion Daily Agribusiness Bear 3x Shares with the ticker “COWS” – fortunately sent out to pasture in 2012.   These types of ETFs are designed for short term trading and often have high fees and clearly don’t provide diversification.  The website “Invest With An Edge” provides monthly stats on ETFs that are launching and closing in the US.  In March, all 17 new ETF launches were different flavours of “smart-beta”, a catch all term for strategies trying to exploit systematic market anomalies using factors like “value” and “momentum” (see recent Chalten post – Are value stocks finally poised to outperform?).  No surprise given the current popularity of that investing trend.

Even John Bogle, founder of Vanguard, which provides some of the best ETFs in Canada, is wary of the product believing most ETFs are created to tempt investors into short term trading and that many are just too risky.  With respect to leveraged ETFs, which can double or triple your bet using derivatives or inverse ETFs which are designed to bet against a particular theme or sector, Bogle is quoted by Yahoo Finance saying “this is where the “fruitcake, nutcases and lunatic fringe” can be found. There’s just no possibility or any realistic way that you’re going to win that bet.”  He does acknowledge that some broad market ETFs are good for investors.

So what is an investor to do?  In Canada we’d suggest starting with well established players like Blackrock iShares and Vanguard.  Look for ETFs that provide broad market coverage for a very low cost.  For example Your Canadian market ETF shouldn’t have fees of higher than 5 basis points (that’s 1/20th of 1%) and you should be able to assemble a globally diversified portfolio of ETFs for 25 basis points or less.

While the latest edition is a couple of years old we also recommend the book Exchange Traded Funds for Canadians for Dummies if you want to learn more.  There are newer and better products available in Canada since this edition of the book was published but it still provides a great foundation for do it yourself ETF investors.