The Simplest Mistake ETF Investors Make

By Nathan Slaughter
September 01, 2010

Ever notice how the simplest task is more complicated these days? Like buying cereal at the grocery store? I just popped in to get a box of Cheerios and was confronted with no less than six different varieties: honey, frosted, chocolate, multi-grain, banana nut and oat clusters.

These products all belong to the same basic Cheerios category. And they have similar packaging and prices. But open the boxes and you find some pretty stark differences inside.

The same is true with exchange-traded funds (ETFs).

Investors usually have a general shopping list in mind: biotech, small-cap, foreign bonds -- whatever. And once we get to those aisles in the ETF supermarket, there are a dizzying number of choices.

It's a common mistake to assume that one fund in a specific category looks more or less like all the others, so we grab the closest box off the shelf without checking the portfolio's ingredients. That's a great way to get vanilla when you really want chocolate.

Many funds look alike on the outside, so it's easy to assume they're built alike on the inside. If crude oil is headed higher, isn't one ETF as good as the other? Is there really much difference between the Vanguard Energy ETF (NYSE: VDE) and WisdomTree International Energy ETF (NYSE: DKA)?

Actually, there is.

One fund is weighted by market capitalization while the other is weighted by dividends. One fund invests mostly in the United States while the other invests strictly overseas. One fund has zero exposure to BP (NYSE: BP) -- for the other, it's the single largest holding.

I'm not making a judgment call on either of these funds, I'm just saying it would be foolish to assume these structurally different funds will deliver identical returns.

You can't tell much from a fund's name without digging deeper. Consider Merrill Lynch's Internet Infrastructure HOLDRs (NYSE: IIH). On the surface, the fund sounds like an ideal way to harness the Internet's vast profit potential. But what exactly are you buying?

Right now, the portfolio has just eight holdings. Six of those are tiny penny stocks. And the other two, Akamai Technologies (Nasdaq: AKAM) and Verisign (Nasdaq: VRSN), soak up 90% of the fund's assets. Even if you like those two stocks, why not just buy them individually and save yourself the custody fees?

You see, the fund is governed by flawed indexing methodology. The sterile portfolio is fixed and can't be rebalanced or reconstituted. So over the years, the original holdings have dwindled: Alteon Websystems, for example, was acquired by Nortel Networks, while Inktomi became part of Yahoo (Nasdaq: YHOO). Portal Software, also a former holding, has been delisted.

This handicap has led to streaky performance and generally dismal returns for investors. In its heyday, IIH used to change hands above $55. Today it trades for less than $4. Long-time shareholders have seen more than -95% of their value wiped out. (Personally, I prefer adaptable funds that can hit the refresh button, particularly in the tech sector, where disruptive changes mean today's highflier is tomorrow's has-been.)

Of course, this is hardly an isolated example.

Popular new products designed to address specific strategies are another potential pitfall. There are ETFs to protect against inflation, to bet on falling home values, even to profit from a widening (or narrowing) of the yield curve.

These funds are innovative and clever, but don't naively assume they all have flawless execution -- that might be a costly mistake.

Case in point: there are concrete reasons to believe the U.S. dollar is headed down the wrong path, but without knowing where they'd land, some investors jumped with both feet into the PowerShares U.S. Dollar Bearish Fund (NYSE: UDN).

The name sounds right. But is this really the best way to hedge against a falling dollar? Probably not. As collateral for futures contracts, the fund holds U.S. treasuries, which I think are overvalued and likely to fall. More importantly, the euro accounts for 58% of the underlying index.

So UDN isn't so much betting against the dollar as it is betting on the euro -- but both are likely to lose ground relative to other currencies. If you own UDN, ask yourself this question: What's to stop the greenback from depreciating in general but gaining against the euro?

Talk about winning the battle but losing the war.

The Investing Answer: Don't assume the work is done just because you've identified a sector, country or theme that sounds promising. You have to go a step further and isolate which product within that niche best fits your goals.

There are now about 1,000 ETFs on the market -- and more are being launched every day. But more options mean more homework.

Familiarize yourself with a fund's tactics -- a traditional issuer like iShares does things different than a quantitative-driven indexer like PowerShares. Which flavor you prefer depends on your own particular tastes.