ETFs To Worry About

February 08, 2010

Some of the most popular ETFs over the past month could hold nasty surprises for investors.

As Dave Nadig pointed out in his most recent blog, investors spent most of January plowing money into Vanguard’s ETFs. He attributed this in part to investors “getting smart” about ETFs: choosing funds with the lowest expense ratios and strong tracking performance, which in many cases meant Vanguard.

I think that’s part of it. Part of it is also that Vanguard’s ETFs tend to attract steady, buy-and-hold investors: the kinds of investors that plow ahead with their monthly contributions regardless of what’s happening in the market. iShares and State Street Global Advisors ETFs, by contrast, attract significant interest from traders, who are more apt to move money in and out of the market in response to volatility.

Besides, looking at which individual funds attracted the most attention in January, I’m not so sure how “smart” all that new ETF money is.

Consider the single most popular ETF in January: the iShares Barclays TIPS ETF (NYSEArca: TIP). TIP has ridden a wave of inflation paranoia to incredible heights. The fund pulled in nearly $1.2 billion in January, and has more than doubled its assets over the past year, from $9.6 billion to $20.0 billion. It is now the sixth-largest ETF in the world, just a smidge behind the iShares S&P 500 (NYSEArca: IVV) ETF.

Investors buying TIPS (and more specifically, TIP) are (perhaps justifiably) concerned about runaway inflation. There's certainly a theoretical sense to this: With an inflation-indexed bond, the value of the principal is adjusted annually based on changes in the Consumer Price Index.

The equation seems simple: Worried about inflation? Buy Treasury inflation-protected securities, and your principal is protected.

What they don’t realize is that the Federal Reserve will likely raise interest rates well before significant inflation is captured in the official CPI. That's not a complete certainty of course, and some very smart people would disagree with me, suggesting that the Fed will leave interest rates near zero well into a recovery. But my assumption is that rates are headed up, and as rates rise, the value of TIPS bonds (indeed all bonds) will fall. That means TIPS investors will likely feel the pain of rising rates before they feel any benefit from CPI-related inflation adjustments.

The impact of rising rates will fall across the full bond spectrum, but it seems like TIPS investors will feel particularly wronged. They will have made the “right” market call—rising inflation—and yet earned subpar returns.

One of the big risks of ETFs is that they open up new asset classes to investors. That’s great, but it sets up some investors for getting burned.


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