Designed as an easy way for investors to make money over the long term, exchange-traded funds are quickly becoming an even easier way for investors to lose money in the short term.
ETFs were created in 2000 to help investors get broad exposure to a variety of stocks. And they're useful because they are:
1. Cheap: Most are run on autopilot, so there are no big money-manager salaries to pay as there are with a mutual fund. 2. Tax-efficient: Most closely track stock indexes, which don't frequently add or lose members, meaning stocks aren't frequently bought or sold. 3. Easy to use: -- They trade on a stock exchange throughout the day, so they can quickly be bought or sold.
So it's easy to see why many investment experts -- like Jack Bogle, founder of the Vanguard Group -- advise that a long-term investing strategy should consist largely of ETFs.
This has led to massive success for these products. After just 12 years, there are more than 1,400 ETFs controlling $1.2 trillion in assets, according to BlackRock.
But with success comes innovation, and newer versions of ETFs could wreak havoc on your portfolio.
Buyer Must Beware
We're specifically referring to leveraged ETFs, which are designed for institutional investors (like hedge funds) to eliminate risk from their portfolio.
The allure is clear: Access to hedge fund type returns for individuals who don't have millions to invest. But most individual investors don't know how to use them -- and they don't understand the risks. Yet there's no regulation prohibiting everyday investors from trading them.
One example recently called out in BusinessWeek is the FactorShares 2X: Oil Bull/S&P 500 Bear ETF. This "leveraged spread" fund is designed to deliver twice the daily change in the spread between the price of oil and the S&P 500.
This ETF is short-term in nature, which alone should be reason enough for individual investors to stay away. But the leverage it employs -- using borrowed money to amplify the return -- is disastrous if the spread is negative.
For example, during the month of February, the fund delivered a return 32% higher than its index.
But if you look deeper, you'll notice that between Feb. 24, 2011 (when the ETF launched), and Feb. 29, 2012, the opposite was true: The index it tracks lost 2.46%. However, the ETF lost even more -- down a startling 18.7%.
These funds aren't evil -- there are benefits to funds like this being available.
As the fact sheet for FactorShares 2X: Oil Bull/S&P 500 Bear points out, it's an easy way to achieve the spread in just one investment. It's cheaper than other tactics. Plus it doesn't require a margin or futures account to be set up.
10 Stocks for the Next 50 Years
Leveraged ETFs: Double Your Money Quick (or Lose It Twice as Fast)
10 Stocks to Buy, Hold and Prosper
Betting on companies that are not only profitable but also have a long history of increasing their dividend payments to shareholders is as good a strategy as you'll find for increasing wealth without exposing yourself to outsize risk.
Each of these 10 businesses has been issuing ever-higher checks to their investors for at least half a century, according to the dividend-tracking site The Dynamic Dividend.
1. Diebold (DBD). This maker of safes and other security equipment yields 3% and pays out 50% of its profits as dividends. Management has increased the average payout by 5.4% annually over the past five years.
2. American States Water (AWR). This company pays a 3.1% yield as of this writing, with 45% of profits committed to dividends. This California water utility was founded in 1929 and has increased its average payout by 3.9% annually over the past five years.
3. Dover (DOV). Shares of this industrial machinery supplier yield 2.1% as of this writing, paying out 26% of profits as dividends. Management has increased the average payment to shareholders by 11% annually over the past five years.
4. Northwest Natural Gas (NWN). It pays a 3.9% yield as of this writing, with 73% of profits earmarked for dividends. This Pacific Northwest gas utility celebrated its centennial two years ago and has increased its average payout by 4.7% annually over the past five years.
5. Emerson Electric (EMR). Another member of the 100-plus club, this supplier of industrial electronics yields 3.2% as of this writing. Roughly 46% of earnings are committed to dividends. Management has raised the payout 9.1% annually over the past five years.
6. Genuine Parts Company (GPC). Yielding 3.1% as of this writing, this auto parts wholesaler pays 50% of profits back to shareholders as dividends. Management has increased the payout by 6% annually over the past five years.
7. Procter & Gamble (PG).You already know P&G -- it's one of the world's most popular consumer products companies, maker of such items as Tide detergent and Pampers diapers. What you might have missed is the company's 3.3% yield, paid from 60% of annual earnings. Management has increased its spending on dividends by 11.2% annually over the past five years.
8. 3M (MMM). Originally known as Minnesota Mining and Manufacturing when founded in 1902, 3M -- the creator of Post-It Notes -- yields 2.7% as of this writing. Management pays out 37% of profits as dividends, and 3M has increased the per-share cut by 3.6% annually over the past five years.
9. Vectren (VVC). Founded in 1912, this central U.S. utility funds a 4.9% yield by paying 80% of earnings back to shareholders as dividends. Management has increased the payout by 2.4% annually over the past five years.
10. Cincinnati Financial (CINF). The riskiest bet in the lot, this property casualty insurer pays out more than 150% of its annual profits as dividends. So while the history and current yield -- 4.6% as of this writing -- are no doubt enticing, management may be forced to curtail payments to shareholders in the coming years.
Should you invest in any of these stocks? That depends on whether you have an interest in learning more about the underlying businesses. And again, don't invest with money you'll need in the next five years. Stocks are wonderful at creating long-term wealth, but they're as dangerous as dynamite over the short term.
But these are concerns of a professional money manager overseeing billions of dollars -- not risks an individual investor should be concerned about.
Individuals should focus on implementing a diverse strategy they'll stick with for years -- one that contains a mixture of stocks and bonds, and one that targets different asset classes (large-cap stocks, small-cap stocks, real estate investment trusts, etc.).