Exchange-traded funds have never been more popular. And no wonder: They're passively managed, which makes them as cheap as indexed mutual funds, but they trade all day long, like stocks. And they tend to be more tax advantaged than mutual funds, given that ETFs very rarely kick off capital gains distributions.

But Wall Street greed might make ETFs the next good investment vehicle to go bad. And several high-powered advisors and analysts see the table being set for investor disappointment.

'The Next Embarrassing Chapter'

ETFs are a terrific invention, says Robert Isbitts, chief investment officer for Emerald Asset Advisors, but segments of Wall Street have seized on the opportunity to commercialize them and are in danger of overdoing it.

When ETFs were in a bull market, providers were launching new funds each week, and the total number peaked in mid-2008, with more than 700 ETFs representing $580 billion in assets. The problem is that ETFs are just another investment vehicle, not a substitute for investment management, Isbitts says, and they should rarely be used in isolation -- the danger with any trendy new product. "ETFs risk being the poster child for the next embarrassing chapter of the investment advisory business," he says.

What's troubling him is that ETFs are being substituted for active management more often than he feels is reasonable -- especially versus time-tested mutual funds. "We use ETFs if there is no mutual fund available that correctly targets the investing style or theme that a client wants," Isbitts says. Wall Street, he feels, is overusing them.

Here's how history can repeat itself, Isbitts warns: A good product idea gets popular with financial advisors, and the product gets mass-produced, with each company trying to one-up its rivals. Increasingly innovative but more complex varieties hit the market. The media start poking holes. Producers and consumers get confused about the pitfalls and risks. Money is lost. And all parties vow not to get fooled again -- until the next time.

Due Diligence and Do Diversify

Bill Schulthesis, a partner with Soundmark Wealth Management and author of The New Coffeehouse Investor, warns that ETFs' proliferation will confuse investors who want to build successful long-term portfolios -- and that Wall Street incites this confusion by encouraging investors to trade ETFs actively by creating hundreds of thinly sliced funds representing every imaginable sector, industry, and trend.

"They've taken all the inherent good qualities of ETFs and stood it on its head by creating a plethora of sector index funds, and then they promote themselves not as stockpicking experts but as sector-picking experts," says Schulthesis. What too many investors fail to realize is that making narrow bets on sectors or slivers of sectors opens them up to increased risk if their overall portfolios are not properly diversified.

ETFs can also underperform their respective indexes, says Anthony Diaz, VP of investments at IFC Advisory. That's especially true with leveraged ETFs, which offer two or three times the long or short return of their underlying benchmarks. These products aren't meant to be held for more than one or two trading days -- but few retail investors know that.

"To be able to use these products well, investors are required to make their own decisions about when and how much to invest in the market," says Ken Kam, CEO of Marketocracy. "These are difficult decisions that most investors aren't comfortable making. That's why investors seek help from Wall Street in the first place."

Avoiding Disappointment

"My expectation is that, as in the past, much of the money that flows into these ETFs will be very disappointed when they see them correlate highly to the next broad market decline," Isbitts says. "We don't need nearly a thousand ETFs -- maybe Wall Street should leave well enough alone."

How can Wall Street avoid an ETF black eye? "Some damage will be done," Isbitts predicts. Potential trouble tends to hang around for a while before its real cost is incurred: The dot-com and housing bubbles lasted longer than many expected. "And just like with those events, the dangers lurking in some corners of the ETF market are bound to grab hold of the most amateur investors -- the so-called 'little guys' -- right before things to wrong," says Isbitts. "That seems to be the trigger point for these things."

The rule of thumb, he says, is that the damage will really start as soon as everyone is convinced that everything is fine: "It's just another one of those contrarian indicators that seem to exist on Wall Street."


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