How investors can be harmed by Exchange Traded Funds

Exchange Traded Funds offer market participants with a low-cost alternative to mutual funds and other portfolio management tools. Exchange Traded Funds are primarily used by investors to gain exposer to a particular industry, market, or product category. Funds can range from the highly popular S&P index offered by Vanguard to the more esoteric funds such as the 3x Leverage Dow Funds. Generally speaking, ETFs can lower investor risk by providing then with a security that is diversified such as the Nasdaq ETF or the S&P 500 ETFs. Here investor hold a subset of American business and benefit in proportion to their respective index’s performance over time.

However, of late, investors are using ETF not as an investment vehicle but as a gambling or speculative investment. Here, the risk is much higher as many investors do not take the time to read the prospectus to properly ascertain what they are holding. In addition, many of these new, more esoteric ETFs come with higher fees which ultimately can lower perspective returns for long-term oriented investors. This highly speculative investments have much higher risk as they are used primarily as mechanism to gamble. As a result, investors are not concerned with the underlying intrinsic value of the holdings, but are instead focused almost exclusively on price movement. This in turn, fuels bubbles as more speculative investors enter the market. The high demand for the funds, spurs further ETF price increases, thus reinforcing the speculative mania. Eventually, as with all bubbles, the market will potentially run out of over optimistic buyers and collapse. This creates large and substantial loses for ETF holders who were speculating and not investing based on the underlying intrinsic value of the businesses held in the ETF. As such, the major risk for ETF investors is partially the expense ratio and partially the overall price of the ETF itself. This is was creates the market risk for investors who pay too high of a price for an asset that isn’t worth it (Ackert, 2008).

The potential for high return is exacerbated by leveraged ETFs which look to double or triple the return of a representative index. These instruments further fuel the speculative fire with “get rich quick,” type of returns. Unfortunately, these securities are very risky due to their embedded leverage. Although it is very possible for these instruments to double the return of an index on the upside, they also double the losses for investors on the downside. If the losses become very large, equity shareholders due to leverage can be wiped out. In many cases, it is not in the best interest of long-term shareholders to participate in these securities if they cannot withstand large volatility within the holdings (Avellaneda, 2010).