By Kirk Shinkle

Perhaps it's inevitable that love for the "next big thing" eventually gives way to skepticism.

It's as true for investing tools as anything else. Just look at the current scrum forming around exchange-traded funds.

Touted by financial advisers and the press as a revolution in transparency, cost, and access to exotic investments, these index funds are now being slammed from several quarters for inefficiencies, hidden fees, and opaque structures. Pundits have been mixing it up in sometimes shrill broadsides, with some arguing that ETFs are just the latest means for investment advisers to hoist flawed products on unsuspecting customers. The volume of criticism is up, even among industry experts.

stock market roller coaster ride

ETFs: Miracle or Menace?

Decidedly, opinion should tilt towards the former.

As the funds evolve from cheap tools for tracking major indexes into a vast forest of products used to trade everything from commodities to countries, there are bound to be some successes and failures in what is still a relatively young asset class. As such, it's worth revisiting a few of the more frequent criticisms of the ETF, and what investors need to know about one of investing's most popular innovations in decades.

ETFs: Tracking Error

Perhaps the most oft-repeated criticism of ETFs is that they don't live up to their reputation as passive index trackers and sometimes miss the mark when it comes to closely following the actual indexes they're designed to replicate.

ETFs are sold largely as passive investments, so the implication is that your investment will track its index minus management fees and taxes in a very tight range. In fact, ETFs never perfectly track their underlying indexes, but they do get close much of the time.

The average tracking error for U.S.-listed ETFs was 52 basis points, with the widest spreads on fixed income and sector or industry funds, according to research by Morgan Stanley. Still, the number of ETFs with high tracking error (above 150 basis points) increased by 25 from 2007, most likely as a result of last year's record market volatility and a growing number of highly specialized funds more prone to such errors. A few factors, including rebalancing or diversification requirements for ETFs, can skew results.

Rob Leiphart, an analyst at Birinyi Associates, says anything over 10 basis points above and beyond the management fees should raise alarm bells.

Some ETF tracking error rules of thumb:

The less liquid the underlying securities are, the higher the tracking error will be. It's easier to mimic hundreds of hotly traded stocks with hefty volume than, say, an index of just a few dozen high-yield bonds that may not even trade every day.

The trade-off for investors is this:

ETFs offer an affordable way to buy into a whole new universe of investments like sectors and industry funds, but tracking error can sometimes add to the cost of the total investment.

ETFs: Index composition

"Buyer, beware" is a common enough sentiment on Wall Street, but with ETFs, it's more a case of "buyer, be wise." You'd (one hopes) never buy a traditional mutual fund without checking out its holdings, and the same goes for ETFs. The composition of similar-sounding funds can vary widely.

For example, Vanguard points out that its Vanguard Emerging Market ETF has 791 holdings versus 338 holdings in its iShares counterpart. Another example: The popular Technology Select Sector SPDR fund (symbol XLK), one of nine sector funds that cover the whole of the S&P 500, underperformed its corresponding S&P sector by 3.93 percent between the start of the year and May 11, in part because the SPDR index includes both technology and telecom stocks, Leiphart notes. It all gets a bit complicated: SPDRs actually track AMEX Select Indexes that correspond with S&P 500 sectors but can include different stocks (in this case, those eight telecom names).

"That's one major, glaring issue," he says. "These AMEX indexes are supposed to be a mirror of the S&P 500 indexes, but they're not."

Remember: Fund composition is carefully spelled out in every ETF's fine print.

Industry leaders (iShares is a standout) go out of their way to make the distinction clear and offer resources and tools to follow tracking error, index composition, and overall returns. The question is whether or not everyday investors are taking the time to dig that deep.

The trouble with oil. Commodities present a unique twist on the indexing problem.

Take oil: If you looked at the price of crude at the start of the year, saw room for a jump, and bought a popular oil ETF to take advantage of the big rise in oil prices during 2009, you already know what's wrong with some commodity ETFs. Between the start of the year and June 1, crude prices rose by almost half. But the popular United States Oil Fund (USO) barely budged into double-digit gains, rising just 13 percent.

The reason? USO is supposed to track the price of West Texas Intermediate Light crude. Except it isn't, exactly. USO tracks crude futures, which means the returns for the index will follow futures prices, not spot prices. When the two diverge notably (known as contango or backwardation, depending on the direction), the indexes diverge as well.

ETFs: International funds

If your ETF is tracking shares of companies listed in, say, China, and the Chinese exchanges are closed, why is your U.S.-listed ETF still bouncing around intra-day?

Again, it's because ETFs are trading accessibility for exactness, which is part of the reason most folks buy them in the first place. What you need to know about such international funds is this: "International [funds], especially in emerging markets, will have larger tracking error in part because the indexes are harder to track, especially in subsections and sectors," says Kyle Waller, an ETF analyst at Wiser Wealth Management. Since ETFs based on foreign shares trade on U.S. exchanges when foreign markets are closed, managers hedge using "fair market pricing" to approximate index changes. They'll reorder the net asset value of a fund if market-moving news hits, or use a mix of U.S.-listed shares of foreign companies called American Depositary Receipts to smooth the changes.

ETFs: Leveraged funds

Possibly the wildest corner of the ETF market is those funds that promise to double or triple returns on their underlying indexes.

Leveraged ETFs come in various shapes and sizes, ranging from the usual round of major indices to sectors like financials or real estate stocks.

For example, the Financial Industry Regulatory Authority notes that between Dec. 1, 2008, and April 30, 2009 "an ETF seeking to deliver three times the daily return of the Russell 1000 Financial Services Index fell 53 percent while the index actually gained around 8 percent." FINRA recently reminded its members of their responsibility to have a "reasonable basis" for recommending such products to customers. Again, they're meant for day-traders only since volatility in the shares can wreak havoc on your returns if you hold such securities for any meaningful period of time (to be safe, "meaningful" means more than a day).

ETFs let you trade all day long. But should you?

Lastly, there's a philosophical disconnect between the idea behind ETFs and how they're being used by traders.

Index funds were developed to offer an option for folks who believe you can't beat the market over the long run, but have actually expanded the universe of tools available to try to do just that.

Vanguard Group founder John Bogle recently took aim at ETF investors' trading habits, analyzing annualized five-year returns for 79 funds against models designed to replicate investors trying to time the market.

He found that ETF investors, in part because of more frequent trading, lagged the market in 68 of the surveyed funds, sometimes by a wide margin. They underperformed the market by 0.4 percent per year in large-cap value funds to as much as 17.9 per year in financial ETFs. He found that investors fared worse in hot sectors like emerging markets, financials, and REITs. Because they're easy to trade, ETFs give index investors a chance to trade more actively.

As a consequence, as Bogle put it, "passive indexing has gotten a lot more like active fund management."


The Case Against (Some) Exchange Traded Funds

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