Investors Want More of This Financial Product, But Beware

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More never seems to be enough when it comes to investment choices. Exchange-traded funds (ETFs) are an innovative financial product that have surged in popularity over the past decade. There is practically an ETF for every corner of the market and map these days. Yet the majority of investors still believe there is room for more. Are they right?

According to a new survey from Charles Schwab, 66 percent of investors say there is room for more ETFs on the market today. Among them, almost 60 percent say more ETFs will result in lower fees through increased competition, while 28 percent credit additional ETF choices as the primary industry trend that has most benefitted investors over recent years. The survey polled more than 1,000 individual investors with at least $25,000 in investable assets who have purchased ETFs in the past two years or are considering doing so in the near future.

“It’s clear that investors expect innovation and choice when it comes to ETFs, but that enthusiasm is coupled with a desire for a deeper understanding of how to choose and use the products,” said Heather Fischer, vice president of ETF platform management at Charles Schwab. “Although 40 percent of investors still consider themselves ETF novices, that group has been steadily shrinking and is down from 45 percent in 2013. What this means is that education remains a top priority but as ETF investors are becoming increasingly savvy, they are seeking products, strategies, and access that go beyond the basics.”

How popular are ETFs? On average, ETFs make up 18 percent of portfolios among those who own them, while one in five owners admit that ETFs account for 25 percent or more of their total investments, up 16 percent from only three years ago. Investors primarily use ETFs for their core or long-term holdings.

Investors are right to believe that there is more room for ETFs, as more competition will lower costs, but investors should be careful about leaving their circle of competence for an exciting new fund that has the potential to blow up their portfolios. Thirty-eight percent of respondents want to gain a better understanding of how to choose and use ETFs, but 71 percent are already confident in their ability to pick an ETF that’s right for them. Furthermore, 63 percent expect to increase their ETF investments in the next year.

One such new product that investors should beware is the leveraged ETF. They are like regular ETFs laced with greed and impatience. They attempt to deliver multiples of the performance of an underlying index or benchmark they track. Some track broad indexes, while others track specific sectors or commodities. Leveraged ETFs seek to magnify returns by using some of Wall Street’s favorite financial drugs: derivatives, futures contracts, and swaps.

Although leveraged ETFs can serve a meaningful purpose to day traders, longer-term investors should steer clear. For example, let’s say an index starts with a value of 100, while a leveraged ETF that seeks to double its return starts at $100. If the index drops by 10 points on day one, its value declines by 10 percent, to 90 points. In theory, the leveraged ETF would therefore plunge 20 percent on that day, with the index’s drop magnified twofold, and have an ending value of $80. On day two, if the index rebounds 10 percent, the index value increases to 99. For the leveraged ETF, its value on day two would also increase by 20 percent, but that 20 percent increase, from $80, would be to just $96.

The leveraged ETF accomplished its goal on a daily basis but failed to keep pace over the two-day period. This gap can grow significantly for buy-and-hold investors and be deadly in volatile markets. It’s even possible that investors could suffer significant losses while the long-term performance of the underlying index shows a gain.

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