Wreck Your Nest Egg: 10 Bad ETFs

  • Beware of Sketchy ETFs

    Exchange-traded funds (which are essentially mutual funds that can be traded like stocks) have offered investors unprecedented access to the financial markets. As ETF assets continue to grow, issuers are forging into increasingly unfamiliar territory. While these ETFs have unprecedented themes, they also can have unprecedented risks. Many of the more complex and nontraditional ETF strategies are appropriate for only sophisticated investors. Nontraditional ETF funds that invest in derivative contracts like futures have been the subject of regulatory scrutiny in recent months. Funds that use leverage to achieve their goals are inherently more volatile than unleveraged ETFs and are designed with sophisticated investors in mind. Leveraged ETFs can be caustic in the hands of long-term, buy-and-hold investors who do not understand their strategies completely. These "10 Most Dangerous ETFs" are funds that are not for the average buy-and-hold investor. As always, potential investors should examine each fund with an eye toward their own goals in order to determine suitability.
    10. Elements Benjamin Graham Large Cap Value ETN (Stock Quote: BVL)
  • 10. Elements Benjamin Graham Large Cap Value ETN (Stock Quote: BVL)

    BVL tracks large, liquid companies like Alcoa (Stock Quote: AA), Wyeth (Stock Quote: WYE) and Allstate (Stock Quote: ALL), but is one of the most illiquid ETFs on the market today. This ETF is one of the smallest of all time, with a market cap of just $1.3 million and a three-month average daily trading volume of 173 shares. It is the lack of investor interest in BVL, rather than its methodology or holdings, that makes this fund dangerous. Illiquid funds can be difficult to trade in and out of, and for a 0.75% management fee, investors can do better. Avoid the trilogy of unsuccessful Benjamin Graham funds, which includes BVL, Elements Benjamin Graham Small Cap Value ETN (Stock Quote: BSC) and Elements Benjamin Graham Total Market Value ETN (Stock Quote: BVT).
    9. TDX Independence 2040 ETF (Stock Quote: TDV)
  • 9. TDX Independence 2040 ETF (Stock Quote: TDV)

    Target-date ETFs like TDV are designed to give investors investment exposure that is appropriate for their retirement date goals. TDX Independence ETFs offers one generic fund and four specific target-date funds with retirement goals of 2010, 2020, 2030 and 2040. As the target date approaches, these funds are designed to shift investor funds from aggressive allocations to conservative allocations. In 2008, both target-date ETFs and target-date mutual funds took a huge blow as the markets slid downward. Target-date funds that were more aggressively allocated for further retirement dates were hit worst. TDV fell 40% in 2008. While the retirement date for its target audience is still far off, these returns are unnerving. Funds like TZD are dangerous because they combine a long-term trading strategy with a product that trades daily on an exchange. It would be difficult to watch an ETF fall 40% and stay invested for the long term. Investors who have any level of financial knowledge are better off building a basic, diversified portfolio rather then putting all their eggs in TDV's basket.
    8. Claymore/BNY Mellon Frontier Markets (Stock Quote: FRN)
  • 8. Claymore/BNY Mellon Frontier Markets (Stock Quote: FRN)

    The risks of investing in this "frontier markets" ETF are not yet worth the potential rewards. FRN invests in the most emerging of emerging markets, areas that are inherently volatile economically and politically. FRN's top five country allocations are Chile, Poland, Egypt, Colombia and Kazakhstan. The three-month average daily trading volume for FRN is a low 13,221. Since the fund is illiquid, investors face illiquidity compounded with inherent volatility. While this fund may be worth a look in the future, for now it is simply dangerous.
    7. UltraShort Health Care ProShares (Stock Quote: RXD)
  • 7. UltraShort Health Care ProShares (Stock Quote: RXD)

    RXD has two things going against it: the fact that it's illiquid and the fact that it's leveraged. ProShares, the pioneer of the leveraged fund industry, released RXD as part of a short/long pair in a series of leveraged sector funds. Leveraged funds have come under fire, with a lawsuit currently against RXD's peer, UltraShort Real Estate ProShares (Stock Quote: SRS). RXD could face similar pressures as time wears on. RXD's average daily trading volume is fewer than 8,000 shares, making this fund dangerously illiquid. While all leveraged funds are risky, RXD's double risk factor makes this fund one to avoid.
    6. iPath S&P 500 VIX Mid-Term Futures ETN (Stock Quote: VXZ) and iPath S&P 500 VIX Short-Term Futures ETN (Stock Quote: VXX)
  • 6. iPath S&P 500 VIX Mid-Term Futures ETN (Stock Quote: VXZ) and iPath S&P 500 VIX Short-Term Futures ETN (Stock Quote: VXX)

    The much anticipated VXZ and VXX offer investors exposure to volatility plays. These ETFs track market volatility through the use of derivatives, and their complex strategies make them appropriate for only the most sophisticated investors. Recent market fluctuations have made the topic of increased volatility a popular theme, and these products could be helpful in hedging a large, multilayered strategy. Average investors, however, should stay away from betting on volatility. Making a bet on volatility by itself is like sitting at a craps table and picking red or black.
    5. MacroShares Major Metro Housing Up (Stock Quote: UMM) and MacroShares Major Metro Housing Down (Stock Quote: DMM)
  • 5. MacroShares Major Metro Housing Up (Stock Quote: UMM) and MacroShares Major Metro Housing Down (Stock Quote: DMM)

    After the failure of two sets of leveraged oil funds, MacroShares has set its sights on the housing market, as measured by the S&P/Case-Shiller Composite-10 Home Price Index. This pair of funds is designed to provide the investor with three times the exposure of this index for both bullish and bearish bets. Rather than investing in stocks or bonds, like other ETFs, UMM and DMM use short-term Treasury securities and overnight repurchase agreements to track their underlying indexes. Perhaps the most dangerous aspect of the funds is that they are designed as paired trusts and pledge assets to each other over time. Generally, fund issuers create additional shares of a fund if investor demand peaks and assets pour in. Since UMM and DMM are tied financially, a creation in one of these funds will spark a creation in the other. The failure of MacroShares' oil funds following the 2008 spike in oil prices does not bode well for UMM and DMM, the last surviving funds from this issuer. Investors should avoid these unconventional leveraged funds and their triple bets.
    4. PowerShares DB G10 Currency Harvest (Stock Quote: DBV)
  • 4. PowerShares DB G10 Currency Harvest (Stock Quote: DBV)

    Trying to earn incremental returns while facing huge potential risk is like trying to pick up pennies in front of a steam roller. DBV has earned the #4 spot on our "10 Most Dangerous ETFs" countdown because - for buy and hold investors - the rewards are not worth the risks. DBV gives investors exposure to the "carry trade," which is one of the oldest trading strategies in finance. Using this strategy, an investor borrows money in a currency with low interest rates and invests it in another with higher interest rates. The goal is to make small profits over time. Historically, the higher-yielding currencies tend to maintain their exchange rate against lower-yielding currencies or even appreciate slightly, and traders can lock in the difference. While this may be just a small amount over time, funds like DBV use leverage to increase the profits. The problem is that this strategy tends to fall apart during times of economic turmoil, or if the currency tide shifts. When the trend reverses, carry trade investors can lose their gains very quickly. Unless you're a sophisticated investor with an eye for currency and timing, stay away from buying and holding DBV.
    3. Direxion Daily Financial Bull 3X Shares (Stock Quote: FAS) and Direxion Daily Financial Bear 3X Shares (Stock Quote: FAZ)
  • 3. Direxion Daily Financial Bull 3X Shares (Stock Quote: FAS) and Direxion Daily Financial Bear 3X Shares (Stock Quote: FAZ)

    While sophisticated traders may find these funds effective daily hedges for more complex strategies, they can be devastating to buy-and-hold investors who don't understand their objectives. Volatile markets can erode leveraged strategies over time, a challenge that FAS and FAZ have recently faced. Here's the math problem with leveraged ETFs: These funds are designed to give you three times the return of their underlying indexes on a daily basis. Each day, these funds "reset," compounding returns over time. Direxion recently executed a reverse split in both of these funds because their prices fell so dramatically.
    2. United States Natural Gas (Stock Quote: UNG)
  • 2. United States Natural Gas (Stock Quote: UNG)

    As the Obama administration makes efforts to coordinate regulatory authorities and crack down on commodity speculators, UNG has found itself in the headlines. UNG's complex underlying strategy has been made riskier by regulatory uncertainty. Here are the top three reasons why investors should avoid UNG. In theory, UNG and United States Oil are "purer" plays on oil and natural gas prices than other ETFs like iShares Dow Jones US Oil & Gas Exploration (Stock Quote: IEO) and Energy SPDR (Stock Quote: XLE) that track equities. While UNG is designed to reflect natural gas prices, it tracks the near-month futures contracts for natural gas, not the spot price. This methodology inherently causes the fund to deviate from its objective, a problem that USO has also encountered. The price of an ETF should reflect the underlying value, or net asset value, of the fund. Unlike closed end funds or mutual funds, ETFs achieve their tracking objectives by the creation and redemption of shares. Regulatory limits caused UNG's creation process to grind to a halt back in July. As fund managers waited for the SEC to approve more shares, UNG began trading at a massive premium to its underlying value. After a summer of premiums, the SEC has approved additional UNG shares, and the fund managers began issuing new shares Sept. 28. As UNG is once again allowed to operate as designed, the creation of new shares should cause the fund to once again trade in line with its underlying value. This shift should eliminate the premium and pop the UNG bubble.
    1. PowerShares DB Crude Oil Double Short ETN (Stock Quote: DTO)
  • 1. PowerShares DB Crude Oil Double Short ETN (Stock Quote: DTO)

    DTO tracks a basket of futures contracts and employs leverage to achieve its strategy. Futures are inherently volatile and leverage adds volatility, so DTO can be one wild ride. Since DTO is structured as an exchange-traded note, rather than an ETF, it is also exposed to the credit risk of its issuer. In an era where once-solid banks have crumbled, credit risk is more of a concern than ever before. When DTO was originally released, it was paired with the PowerShares DB Crude Oil Double Long ETN (Stock Quote: DXO). On Sept. 9, DXO was shut down by its managers because the fund's size had triggered regulatory limitations. While DTO has yet to achieve the popularity of its former pair, investors in this fund should be wary of a potential shut-down. The Financial Industry Regulatory Authority has also recently issued warnings about the risks of leveraged funds. Additional margin requirements will be imposed on Dec. 1. Since DTO is both leveraged and futures-based, this fund faces double the regulatory uncertainty in the months ahead. Normally, futures-based and leveraged products like UNG and DTO would be appropriate for sophisticated investors who understand the underlying risks. Because of the regulatory uncertainty, however, these products could be dangerous to any investor if requirements suddenly change.
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