Designed as an easy way for investors to make money over the long term, exchange-traded funds are quickly becoming an even easier way for investors to lose money in the short term.
ETFs were created in 2000 to help investors get broad exposure to a variety of stocks. And they're useful because they are:
1. Cheap: Most are run on autopilot, so there are no big money-manager salaries to pay as there are with a mutual fund.
2. Tax-efficient: Most closely track stock indexes, which don't frequently add or lose members, meaning stocks aren't frequently bought or sold.
3. Easy to use: -- They trade on a stock exchange throughout the day, so they can quickly be bought or sold.
So it's easy to see why many investment experts -- like Jack Bogle, founder of the Vanguard Group -- advise that a long-term investing strategy should consist largely of ETFs.
This has led to massive success for these products. After just 12 years, there are more than 1,400 ETFs controlling $1.2 trillion in assets, according to BlackRock.
But with success comes innovation, and newer versions of ETFs could wreak havoc on your portfolio.
Buyer Must Beware
We're specifically referring to leveraged ETFs, which are designed for institutional investors (like hedge funds) to eliminate risk from their portfolio.
The allure is clear: Access to hedge fund type returns for individuals who don't have millions to invest. But most individual investors don't know how to use them -- and they don't understand the risks. Yet there's no regulation prohibiting everyday investors from trading them.
One example recently called out in BusinessWeek is the FactorShares 2X: Oil Bull/S&P 500 Bear ETF. This "leveraged spread" fund is designed to deliver twice the daily change in the spread between the price of oil and the S&P 500.
This ETF is short-term in nature, which alone should be reason enough for individual investors to stay away. But the leverage it employs -- using borrowed money to amplify the return -- is disastrous if the spread is negative.
For example, during the month of February, the fund delivered a return 32% higher than its index.
But if you look deeper, you'll notice that between Feb. 24, 2011 (when the ETF launched), and Feb. 29, 2012, the opposite was true: The index it tracks lost 2.46%. However, the ETF lost even more -- down a startling 18.7%.
But these are concerns of a professional money manager overseeing billions of dollars -- not risks an individual investor should be concerned about.
Simpler Is Often Better
These funds aren't evil -- there are benefits to funds like this being available.
As the fact sheet for FactorShares 2X: Oil Bull/S&P 500 Bear points out, it's an easy way to achieve the spread in just one investment. It's cheaper than other tactics. Plus it doesn't require a margin or futures account to be set up.
Individuals should focus on implementing a diverse strategy they'll stick with for years -- one that contains a mixture of stocks and bonds, and one that targets different asset classes (large-cap stocks, small-cap stocks, real estate investment trusts, etc.).
And that's the best way to achieve long-term wealth and a comfortable, happy retirement.
This article was written by Motley Fool analyst Adam J. Wiederman. Click here to read Adam's free report on how to ensure a wealthy retirement.