3 ways to avoid trouble with exchange-traded funds

While exchange-traded funds are lauded for their low fees, experts warn that this increasingly popular type of investment is getting away fromits roots and that can spell trouble for the unwary.

Complex new products are hitting the market and they come with potential pitfalls for investors.

Here are some things to watch out for when investing in ETFs:

Rising fees

When TIPS, the original name for ETFs, launched in 1990, their selling point wasnt active management or the ability to beat the index. They were just a way of offering broad market indexing at rock bottom prices.

Most funds pay the managers who run them through something called the Management Expense Ratio (MER). Expressed as a percentage of the funds total assets, its the amount that gets taken out of the funds assets to pay for things like trading fees and salaries for fund managers.

'Any [management fee]over two per cent for a simple equity fund is wacky.' David Chilton, author of The Wealthy Barber

Generally speaking, Canadian MERs are higher than anywhere else in the developed world. The fund industry has never offered a satisfying reason for why that is, and ETFs have definitely profited by appealing to Canadian investors looking for a cheaper option.

"ETFs brought pressure on the industry to get fees down, and that's a very good thing," financial author David Chilton told CBC.

Case in point: Globally, Vanguard is seen to be among the lowest-cost ETF providers in the world. So, many cheered when the company finally launched Canadian offerings on the TSX in October 2011. On the fee side, they didnt disappoint Vanguards broad MSCI Canada fund charges a microscopic MER or 0.09 per cent. Its U.S. Broad Market fund charges 0.15 per cent.

Contrast that with the 2.31 per cent that fund rating company Morningstar says the "average" Canadian equity mutual fund charges.

They dont sound like much, but make no mistake, those fees add up. Assuming an average five per cent annual return, a lump sum of $10,000 invested over 45 years in a fund that charges 0.5 per cent will end up giving $17,783 to the fund manager, while the investor gets $72,066. But if that management fee jumps to 2.5 per cent, the investor ends up making less than half what his professional help does, with $60,356 going to the manager and only $29,493 going to the investor.

"Anything over two per cent for a simple equity fund is wacky," Chilton says.

What are you buying?

The fees might be better, but its not always easy to know what youre buying with any given ETF.

It doesnt take a genius to decipher whats under the hood of the popular iShares S&P/TSX 60 Index Fundthe $11 billion fund tracks the performance of the 60 largest companies on the TSX, with a spartan 0.17 per cent MER.

The reality is that with the more niche products coming to market, increased leverage, derivatives and arbitrage strategies are making for unexpected returns.

But what, exactly, is the Canadian Jantzi Social Index Fund, for example? Or the Alternatives Completion Portfolio Builder fund?

Investors might think theyre buying into an investment thesis, such as "socially responsible companies" (like the Jantzi fund) or even "alternative investments" like those in the Completion Portfolio Builder fund. But the reality is that with the more niche products coming to market, increased leverage, derivatives and arbitrage strategies are making for unexpected returns.

Take Claymores U.S. listed Natural Gas Commodity ETF (ticker symbol GAS on the NYSE). Investors who bought the fund no doubt thought they were getting a straight play on natural gas prices. In 2009, for example, spot natural gas prices went up by 3 per cent. But the GAS fund lost 61 per cent because it doesnt own physical gas (youd need storage space to hold a billion cubic meters of natural gas to do that)it actually owns futures contracts.

Those contracts were whats known as "in contango," meaning the price of the futures contract was trading above the actual spot price when the contract expired. Those futures have to be rolled over every month, which locks in losses every time that happens.

The lesson? Even if youve correctly called the direction gas prices are headed, a natural gas ETF wont necessarily track the price of natural gas.

It gets even more confusing. Some ETFs are pitched as solid plays on any given investment strategy, when in reality the funds performance is likely to be affected by many unrelated factors.

Take the NYSE-listed Global X Lithium ETF (Ticker symbol: LIT). The fund aims to track the performance of "the largest and most liquid listed companies that are active in the exploration and/or mining of lithium," a metal thats projected to increase in value because its a key component in batteries. Demand for those batteries, in turn, is forecast to expand exponentially as everything from mobile devices to electric cars become more prevalent.

If you buy that investment thesis, LIT might be a great investment. But a closer look at the funds holding shows its just as likely to move up or down no matter what happens to lithium prices. The top holding in LIT, for example, is Sociedad Quimica Y Minera, a Chilean agriculture and mining company thats listed on the NYSE under the ticker symbol SQM. A whopping 24 per cent of LITs assets are invested in SQM.

But a look at SQMs latest annual report shows only 8 per cent of its revenue in 2011 came from lithium and derivatives. Anyone hoping for a pure play on lithium prices would likely be disappointed to discover that one quarter of their lithium ETF is invested in a company that earns 92 per cent of its revenue from things that arent lithium.

The lesson here is that even if the investment thesis is accurate, with some of the newer exotic ETFs theres no guarantee what the execution of that strategy will be.

Not buy-and-hold

Another criticism of the ETF explosion is that many of the newer products arent designed to be bought and held for extended period, but retail investors still seem to think they are.

'Think of leveraged ETFs as power tools fantastic for those who know how to use them, but for those who dont they have a greater potential to cause harm.' Larry Berman, ETF Capital Markets

Take Horizons popular BetaPro bull and bear ETFs. The two funds are designed to exaggerate the direction of the TSX on any given day. By using leverage and futures contracts, the two funds aim to double the returns on the TSX a 1 per cent gain in the index, for example, would translate to a 2 per cent gain for the bull ETF, and a 2 per cent loss for the bear ETF.

Theyre great tools as short-term hedging strategies or easy ways to short-sell in down markets, but a bad guess can quickly evolve into serious losses. Even if an investor guesses the direction of the markets properly, the odds of having an uninterrupted movement in any one direction over a longer time frame are quite low.

"They are not for the casual investor, however, as one must fully understand how they work in order to avoid unexpected and potentially detrimental results," money manager Larry Berman of ETF Capital Markets says.

"Think of leveraged ETFs as power tools fantastic for those who know how to use them, but for those who dont they have a greater potential to cause harm."