4 Of The Biggest Risks Related To ETFs

May 09, 2014

2. Beware of exotic ETFs—anything that’s not a “plain vanilla” fund.

ETFs have come a long way from the launch of the SPDR S&P 500 ETF (SPY | A-97) 21 years ago, to an industry that now includes nearly 1,600 different funds in the U.S. alone, tapping into just about every corner of the market.

Today an investor of any size can own not only stocks and bonds, but commodities, currencies, single countries, emerging market debt—and anything in between—in an ETF wrapper.

Herein is the risk: The more you move away from plain-vanilla funds, the more you could run into an exposure so exotic it doesn’t really deliver what you were looking for.

For example, in the oil-linked ETF segment, there is a handful of competing funds that offer exposure to oil, none larger or more liquid than the U.S. Oil ETF (USO | A-99).

USO is the most popular oil ETF in the market today, but it offers an imperfect way of tracking the spot price of a barrel of oil because it invests in near-month Nymex futures contracts rather than in oil. By owning these derivatives, USO’s returns can diverge significantly from the spot price of oil.

This type of complexity stemming from other-than-plain-stock funds also has tax implications. ETFs trade like a single stock, but when it comes to taxes, it’s the underlying holdings that dictate what tax treatment a fund gets.

For example, if you hold a fund like the SPDR Gold Trust (GLD | A-100), and you decide to sell it after a year, you won’t pay the long-term capital gains tax rate at the time of sale even though GLD trades like a single stock.

That’s because GLD owns physical gold—a collectible, according to the Internal Revenue Service. Collectibles are taxed at a 28 percent tax rate no matter how long you hold them. For taxation details on GLD and other types of off-the-beaten-track fund, check out ETF.com analyst Dennis Hudachek’s “Definitive Guide To 2014 ETF Taxation.”

 

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