Due Diligence Is Key for New ETFs

01/04/2013 8:30 am EST

Focus: ETFs

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Doug Fabian discusses how investors should assess the flood of new ETFs, and why a certain type of mentality is needed for many of the leveraged ETFs.

We're talking today about the state of the ETF world with our guest Doug Fabian. Doug, there are a lot of new products out there. Some seem to be working, some not. What are you seeing?

Well, there has just been tremendous growth in the ETF world. Over 1,400 funds now, and $1.2 trillion in assets. Halfway through the year, I looked at the number of new ETFs that have been brought to the market: 102. So, the industry continues to create new products to see what's going to work.

And if an exchange traded fund can gather assets, then that's going to end up being a profitable venture. Because you have to realize that an exchange traded fund, when you bring it market, you have to put seed money in and you have to market it, but then you have lawyers' fees and accountants' fees and all kinds of things. It's a business, and if you don't get enough assets in the door, that business is going to fail.

One of the things that we were talking about is how a lot of ETFs are just going to the shelf, and that's OK. I mean, you know, we don't need 50 flavors of vanilla. You just don't need that. So there are some ideas that are good, some ideas that are not good, and the industry is continuing to try to put everything they can think of into an ETF format.

So for an individual who hears about a concept and they think wow, that does sound like a good idea, what's the best way to do some due diligence?

Well, I really believe that you need to, you know, dig a little bit further into what's happening there. For instance, there have been some new actively managed exchange traded funds. PIMCO came out with a Total Return ETF (BOND). They have gathered $1.7 billion in 12 weeks. And Bill Gross is running the fund and the fund is doing great. Everybody's happy.

I'm using it for my clients. I'm using it for subscribers. You know it's a very good product, and the proof is in the pudding. They've been able to garner the assets, and we've got a really good manager. So that's working.

You have to kind of look at what is being offered. Does it make sense? Is there anything else out there? But you can't just jump on the latest new widgets-you have to do a little bit of due diligence to kind of understand what's going on.

I will not invest in an exchange traded fund that doesn't have $100 million in assets. So that's just my kind of mark, and it takes a little while to gather that much money in a new offering.

Are there any ideas that maybe people should be sort of leery about when they first hear these?

Well, I believe you have to be. There are a lot of inverse and short leveraged ETFs. These are like options. You know, I'm not an options person and I don't recommend options and they're not my field of expertise, but I know people make money in options.

But the house usually wins. The people who are selling the options are the ones that really make the money in the options. The leveraged ETFs are much the same way. The people who are offering these ETFs are making a buttload of money.

And other people are just, you know, trading them, and trying to, you know, time the market on a short-term basis and hedge their portfolio positions. But for most people, if you're going to use a leveraged or an inverse ETF, it should be on a very tight time frame.

I've gotten e-mails from people. "Oh, I bought Bear 3x Shares (FAZ) and I bought it six months ago and it's down 40%, what do I do?" Well, geez, man, I can't help you now. So that was just a bad idea. It was a bad stock that went down. You need to kick it out of your portfolio and move on.

It seems like a lot of ideas maybe are hot for a time, but when they no longer are, nobody tells the customer it's time to sell.

Well, you have to go into the ETF world-especially the specialized exchange traded funds that are using leverage or that are inverse the market-with a trading mentality. It's going to be a short-term trade. They're just not long-term tools.

Where there are many products, all of the products, Vanguard, you know, all of those are long-term investment vehicles that are long-only investment vehicles. You know, you can find an appropriate spot for that in your portfolio.

One of the biggest innovations that I've seen is just the number of fixed-ncome or income-generating vehicles that are out there now. Two years ago, there were hardly any, and now there's a lot of good ones.

Related Reading:

Finding the Best US Equity ETFs

Best Sector Bets for the New Year

5 Most Important Patterns for ETF Traders

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