ETFs: Not So Simple Anymore

There's no doubt that exchange-traded funds have captured investors' imaginations. The funds, which trade like stocks, represent baskets of securities or commodities. Since 1999, assets have grown at a compound annual rate of 36%. As investors fled mutual funds last year, ETFs garnered net sales of $182 billion.

An ETF offers instant diversification, representing a swath of the market in a single security. You can trade an ETF at any time, and its underlying assets are disclosed daily.

Without the administrative costs of mutual funds, they're dirt-cheap. Bond giant Pimco entered the ETF market in June and is currently charging just 0.09% of assets for its 1P3 Year U.S. Treasury Index (symbol TUZ). Because most ETFs track indexes that don't change much, you'll rarely get a tax bill for capital-gains distributions.

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But ETFs are increasingly complex, and they have their shortcomingsQsometimes even a dark side.

Although they may sound similar, not all exchange-traded products are equal. Investors in Lehman Brothers exchange-traded notes found out the hard way that ETNs do not convey ownership of an underlying asset, but the promise, wholly dependent on the issuer's creditworthiness, to provide a return. Gold and other metals-based ETFs are popular inflation hedges. But when you sell your shares, they'll be taxed as collectibles, meaning a capital-gains rate of up to 28%.

Index-tracking errors are another headache. ETF issuers dream up ways to emulate an index, with varying degrees of success -- particularly when underlying assets are illiquid or hard to invest in. And not all indexes are ETF-worthy. "Most indexes that come to us are rejected," says Benjamin Fulton, of Invesco PowerShares. "Only about 2% make it through."

Like closed-end funds, ETFs can trade at a premium or a discount to underlying assets. That happens mostly when the markets for underlying securities are frozen, closed or otherwise illiquid, as when fixed-income ETFs traded at steep discounts at the height of the credit crisis.

The most controversial ETFs also happen to be among the fastest-growing. Leveraged ETFs, which magnify market swings, and inverse ETFs, which move in the opposite direction, claim 27% of ETF trading volume. But according to TrimTabs Investment Research, investors in leveraged ETFs betting on market gains have lost 58% of their money since September 2006, while those making leveraged bets on a market decline have barely broken even (see The Perils of Leverage).

Because these ETFs track swaps and other derivatives that settle daily, they buck ETF norms with huge capital-gains distributions. Last year the Rydex Inverse 2X Select Sector Energy ETF paid out 87% of assets in short-term gains.

Most investors will do best by sticking with a handful of ETFs in broad asset categories and ignoring the exotica, says Casey Smith, an investment manager in Marietta, Ga., who uses ETFs exclusively. "Don't be the person who has to have a new car every year," says Smith. "The old car isn't the sexiest thing out there, but it works just fine."