The Pitfalls of Nontraditional ETFs

The following are notes from comments I recently gave on the pitfalls of investing in nontraditional ETFs.

The regulators would be wise to keep an eye on non-traditional ETFs. The original ETF structure was something that should be celebrated. It added a new level of liquidity and tax efficiency and lowered trading costs for investors who would have normally used mutual funds as their default investment vehicle. There is little not to like.

Unfortunately, the same cannot be said for some of the more exotic issues of late. I was just discussing Master Limited Partnership (MLP) ETFs and ETNs and the drawbacks of both. In the case of the ETN, JP Morgan runs a very popular option that trades under the ticker symbol $AMJ. Unlike ETFs, which hold the underlying shares of the companies they track in trust, an ETN is not much more than a bond. JP Morgan promises to pay investors a return equal to the return of the MLP index.

This is not a deal breaker, and I myself hold shares of AMJ for clients. But many of the people buying this security are completely unaware that it is not really backed by anything other than the full faith and credit of JPMorgan. And after the 2008 meltdown, that means less than it used to.  (As a secondary issue, the distributions from AMJ are taxed at a much higher rate than on the MLPs its tracks.  This isn’t an issue in an IRA account, but it is a major irritant for a taxable investor.)

The popular Alerian MLP ETF, which trades under the ticker $AMLP, is a true ETF in the sense that it holds shares of its underlying positions like a traditional ETF. But because of the accounting issues with MLPs, AMLP has an enormous hidden fee in the form of a “deferred tax liability.” I’ll spare you the details of what that actually means, but suffice it to say, the much-heralded tax benefits of traditional ETFs do not apply here.

Commodity ETFs and ETNs are also particularly problematic because, with few exceptions, they tend to use futures rather than physical commodities. (The popular $GLD is an exception; it holds physical gold in a vault.) There is nothing inherently wrong with futures for investors and traders that understand them. But most people buying, say, the oil ETF $USO, have no idea that they value of the fund erodes every month due to contango (i.e. negative roll yield). Contango is an issue that could warrant an entirely separate article, but I’ll summarize it like this: due to excessive passive investor (i.e. ETFs, mutual funds, etc.) interest in the front month contract, the price of the contract gets pushed up above the spot price. As the contract approaches maturity, its value falls to match the spot price.

Think of it like this: rather than buying low and selling high, the ETFs are perpetually buying high and selling low. This is why so many of them have underperformed the commodities they are supposed to be tracking. Frankly, it borders on criminal negligence.

A good manager knows how to mitigate or avoid these risks. This is one of those times where paying a professional manager with expertise in the area you are looking to invest in will generally make more sense than going the passive index/ETF route.