Topic: ETFs

Why investors should be wary of many new ETFs

Canadian ETFs

While new investment products can be enticing, a lot of new ETFs mean higher prices and more risk.

The best ETFs represent a low-cost, tax-efficient way for investors to make money in the long term.

However, as often happens after the successful launch of any new investment product, the financial industry soon came up with new ETFs. The “new” models came with a wider variety of investor appeal, along with new wrinkles and extra costs.


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New ETFs: Often a tool for financial companies to make money

Many new ETFs aim to broaden investment opportunities for investors, and create new profit opportunities for the financial companies that sponsor them.

Instead of giving you a low-cost way to copy the results of a standard market index, a lot of new ETFs aim to mimic much narrower indices and higher-risk strategies. They may give you a way to invest in a particular foreign stock market—coupled, in many cases, with an arrangement that hedges against movements in the currency that foreign market trades in. Or they may give you a way to participate in a particular stock-market strategy.

MERs and new ETFs

MER stands for Management Expense Ratio. MERs let you know how much mutual funds and ETF providers charge for the management of their funds. These management fees come directly from the assets of the funds, which serves to lower the investor’s return.

Management expense ratios are one aspect of investing everyone should know about because they affect your long-term gains. They are typically much lower on ETFs than on conventional mutual funds because most ETFs aim to mirror the holdings and performance of a particular stock-market index.

With that said, it’s important for investors to research and review the management expense ratio of every ETF in which you might invest.

Some new ETFs carry somewhat higher MERs than the old ones. Based solely on MERs, they’re still cheaper to invest in than conventional mutual funds. But higher MERs are just one difference.

Many new ETFs feel the need to delve into trading or derivatives of various sorts to accomplish their stated objectives. Rather than raising the ETF’s returns, these added costs act as a drain on its capital. But the effect is the same whether they act as a drag on the fund’s capital growth or speed the shrinkage in its value.

You might say these ETFs act as loss leaders for the industry. The institutions involved make little profit if any on the initial sale and yearly MER. They make up for it with profits from associated activities.

Should you buy new ETFs?

We think you should stick with “traditional” ETFs. However, when an investment product faces booming demand as ETFs do today, investment companies try to expand sales by creating new versions of the underlying formula.

These new ETFs use a conventional stock-market index as a base, but add their own refinements. These refinements are tailored to current investor preferences or prejudices. That’s distinctly different from the traditional ETF, which simply aims to mimic an index. These newer, theme varieties may attract attention—and sales—but they frequently carry higher MERs.

In some cases, the new ETF may provide investment benefits but not consistently. In fact, it may hurt results in the long run. The worst cases are bad enough to lead to big losses. One sure result is that the higher MERs will cut into the value of your ETF portfolio every year.

Another drawback to the new ETF is how much easier it is for investors to act on an urge to invest in a specific stock or stock group without doing any messy and time-consuming research. If you want to invest in oil stocks or gold stocks or Swedish stocks or wind power stocks, or any of hundreds of other stock groups, you can act on that urge. However, that may not produce the best results.

Bonus Tip: What you should know before buying ETFs

Investors use ETFs in a variety of ways. To make the best use ETFs, you should know both the advantages they offer, and some potential drawbacks.

Diversification is one of the most attractive features of ETFs. An investor could create an entire portfolio solely from a few well-diversified ETFs.

Typically ETFs are more tax-friendly and have lower fees than their corresponding mutual funds. That does not mean costs can’t mount up.

Have you had positive results that support the buying of new ETFs?

Do you think newer ETFs are an upgrade on traditional ETFs? If so, what would you tell other investors about them?

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