“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. But ETFs are increasingly complex, and they have their shortcomingsQsometimes even a dark side,” Anne Kates Smith Reports From Kiplinger.

“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%,” Smith Reports.

“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,” Smith Reports.

“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,” Smith Reports.

Full Story: HERE

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