Exchange-traded funds – ETFs for short – are billed as among the most investor-friendly products ever created, thanks to low fees, intraday pricing, and unprecedented flexibility versus the mutual funds they've ostensibly "replaced."
In reality, ETFs are yet another Wall Street creation designed to separate you from your money.
Proponents will undoubtedly cry foul, as will many Wall Street professionals when they read this. That's understandable – they've got a lot to lose. According to Morningstar, there are more than 1,400 ETFs trading in U.S. markets, holding an estimated $3 trillion in assets. In 2005, that figure stood at $300 billion. In 1990, it stood at nothing.
We're going to talk about why that's the case today and, of course, four key takeaways every ETF investor should understand.
Don't get me wrong – ETFs aren't a landmine if you understand how to use them, as I'm about to show.
Chance, to paraphrase Louis Pasteur, favors the prepared mind…
…to which I'll add "especially when it comes to profits."
A Quick Bit of History Sets the Stage
To understand why ETFs are such a rigged game, we have to go back to another Black Monday – Oct. 19, 1987.
I recall it very clearly.
On the heels of what had been a banner summer and two rockin' years leading into that fall, the markets were fueled by a combination of low interest rates, merger mania, and leveraged buyouts. Then, as now, debt was key and IPOs were hotter than hot. The character Gordon Gekko, played by Michael Douglas in the 1987 movie "Wall Street," figured prominently in the social meme when he said: "Greed is good."
At the same time, insider trading was rampant and the SEC was clamping down, despite being outmaneuvered at nearly every turn. Traders turned to hedging as a means of protecting against temporary downturns. This, too, should sound familiar.
To keep things from getting completely overheated – and you knew this was coming – the Fed stepped in to increase short-term interest rates. Predictably, all hell broke loose.
Keen to protect their positions, institutional managers scrambled and billions of dollars' worth of sell orders hit on Oct. 19 within minutes. I stood slack-jawed as the tape went by.
While the institutional damage was bad, the individual experience was worse.
Those holding mutual funds were particularly hard hit because they couldn't sell until the markets had closed. By then the Dow had fallen 22.6% in a gut-wrenching one-day drop that saw nearly $500 billion wiped from the slate.
Never mind that the markets recovered quickly. The damage had been done – there had to be a way to sell during market hours using investments covering a basket of securities.
Three years later, State Street Global Advisors launched the first U.S. ETF. Created to track the S&P 500, the Standard & Poor's Depository Receipts ETF is now known as the SPDR S&P 500 ETF Trust (NYSE Arca: SPY), or "spider" for short. Other broad index-based alternatives sprung up in short order.
Today there are more than 1,400 ETFs covering everything from indices to very, very specialized investments, from the iPath Dow Jones-UBS Livestock Subindex Total Return (NYSE Arca: COW) to the Market Vectors Gaming ETF (NYSE Arca: BJK).
According to Wall Street, they're vastly superior to mutual funds because they have higher daily liquidity, lower fees, and can be traded throughout the day.
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.