As exchange-traded funds push further into niche markets and use derivatives or other complex strategies, financial advisors and investors need to use caution before they buy.
Two Morningstar analysts warn investors that there have been a spate of ETF launches that may do more harm than good.
Dan Sotiroff, senior manager research analyst for Morningstar, said, in some cases, niche strategies may be worthwhile investments but, “Increasingly, what we’re seeing is appealing to people’s worst behaviors, speculation, gaming … ETFs with two-times leverage.”
David Carey, manager research analyst for Morningstar, concurred, pointing to examples such as riskier, single-stock or derivatives ETFs, which can get investors in trouble.
“An ETF wrapper doesn’t fix a bad strategy,” he said, later adding, “I think investors still need to be just as cautious about ETFs than they ever have before.”
Carey and Sotiroff spoke Wednesday at the Morningstar Investments Conference in Chicago about how ETFs have evolved.
Sotiroff said with the big fund-issuers like Vanguard, BlackRock and State Street Global Advisors having launched the basic ETFs investors use, smaller fund companies are looking for ways to get business.
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“Increasingly, we’re seeing a lot of stuff that Vanguard, BlackRock or State Street won’t touch,” he said, adding that many of these sketchy ETFs have maybe a few million in assets, which leaves them at risk of closing.
The easy advice, Sotiroff said, is for investors to stick with tried-and-true investments and avoid ETFs if they don’t understand the investment process.
Carey said the other big trend in ETFs is that active ETFs are here to stay, noting that during the first five months of 2024, 38% of all ETF flows have gone into active ETFs.
“It’s not only the asset managers that are saying this from a top-down perspective and just giving clients all these different choices to connect to ETFs. It seems that investors are also more willing to invest,” he said.
As investors look at new ETFs, both analysts said they should look closely at the team managing the strategy, see that it’s a proven strategy, that the team has the resources to implement it and that they are willing to admit mistakes. Investors should look for managers with experience in several market cycles and processes that are easy to understand and execute.
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