My wife is a health coach so you won’t be that surprised to know that I “try” to watch what I eat. Consuming healthy products involves education and taking the time to actually know what you’re ingesting. Reading the ingredients is important. Investing in financial products is similar.

With the explosion in popularity of Exchange Traded Funds a whole series of financial food has hit the market. All sorts of exotic packaged products are now available for investors. In fact, according to Bloomberg, there are now more indexes than stocks and the ETFs that are being built to track some of these are growing rapidly in number! (Note: there are already more mutual funds than stocks).

Obviously this plethora of options can be confusing and could, in some instances, be damaging to your financial health if you are not careful to take the time to understand what you’re consuming. Here are three pitfalls to consider to ensure your diet of financial packaged goods doesn’t become unhealthy:

1. Caffeinated energy drink: when you slam back sugary and highly caffeinated drinks the initial euphoria and buzz can be exhilarating. The problem is that the crash that occurs post consumption can be problematic to say the least. The side-effects can often not be worth it.

This is where three-times (and even four times!) levered ETFs enter the store. They are typically priced on a multiple of daily moves. So, for example, if gold miners move 1 per cent, then any three-times levered gold miner ETF will move 3 per cent. Sounds good if you somehow have the ability to trade daily moves accurately but there is a dark side. If the underlying asset moves only fractional every day you will wobble around losing very little money but the math works against you quickly when the moves are large. As an example, the table shows a hypothetical set of daily moves and the subsequent prices comparing the underlying asset with a three-times daily levered ETF starting with $100.

Note how the underlying investment is up after 7 days but because of the structure and nature of the 3x “daily” pricing, the levered ETF is actually down. This is maybe the biggest misconception of these products — they do not mirror the longer term performance on the underlying assets which they are levered too. The side effects can be worse than the rush.

2. Fat-free (but full of sugar): Have you ever grabbed that packaged food that says fat free and thought, “Great this is healthy”. Then you started reading the package and noted that it may not have an ounce of fat but it does have a ton of sugar! Same can be said for some ETFs which may be deceiving in there composition.

I’ll give you one quick example of this. Let’s say you think it’s healthy to be long Germany for a series of macro reasons — strong economy, best-functioning labour market and strongest government fiscal position. As a result, you rush out and buy the iShares MSCI Germany ETF believing it to be the healthiest European product.

Did you know, however, that upon consuming this you are very long the automobiles (~13 per cent automobiles and components versus less than 1 per cent in the S&P 500 Index)? Do you want to be long chemicals (~12 per cent of weight)?

Have you considered that the holdings in this product may actually have more to do with global trade and production than the domestic German economy? You may think you are consuming something but in reality, based on the underlying ingredients, you are actually ingesting something unexpected. Again, the package may say one thing but the ingredients may not be exactly what you expected.

3. Spam ETF: I’m not sure what Spam really is. I’m pretty sure it’s not that great for you. Like Spam and hot dogs, some ETFs are full of mystery. Their composition is not exactly straightforward. If there is one thing that is hazardous to your health, it’s a high expense ratio born from a strange structure. The perfect example of this is the Market Vectors BDC Income ETF. Let’s quote Investopedia which does a great job explaining this:

“The Market Vectors BDC Income ETF only charges a direct expense ratio of 0.58 per cent. However, the Securities & Exchange Commission requires that BDCs also disclose their acquired fund fees and expenses, the cost of acquiring their investments, as part of their expense ratios. The fund’s direct expense ratio of 0.58 per cent coupled with its AFFE of 9.04 per cent and adjusted for a 0.17 per cent fee waiver brings the fund’s overall expense ratio to 9.45 per cent as of March 2, 2016. This is the highest in the ETF industry.”

Surprise!

ETFs are great products. They offer instant diversification and liquidity. They can be a healthy component of any investment plan. Just make sure that you are making the right choice by reading the ingredients.

Sources

“Mutual Funds Ate the Stock Market. Now ETFs Are Doing It”, by Justin Fox, Bloomberg View (goo.gl/qnz53Z)

“The 5 Highest Expense Ratio ETFs (BIZD, YMLI) | Investopedia”, by David Dierking, Investopedia (goo.gl/ssmh92)

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.