This article was originally published in February 2012.

Losing money is a risk inherent in the purchase of any financial product. Therefore, be it a stock, bond, mutual fund or ETF, investors expect correct, timely and complete information.

Indeed, an entire industry has developed around compliance and disclosure. The risk of losing money in ETFs can be broken into three component parts:

  1. Cost
  2. Stupidity
  3. Counterparty/credit

Highest risk of losing money: Cost

One rarely knows the return of an investment beforehand; but the cost of that investment is very calculable, and represents the greatest certainty of reducing capital for any product. Despite this fact, it’s stunning how many investors have no real understanding of what they pay for products and services.

Some synthetic ETFs use swaps in their construction. In Canada these include Horizons S&P/TSX 60 Index (HXT) and Horizons S&P 500 Index (HXS).

Part of the cost of these products is the swap fee paid to counterparties to deliver the return of the underlying index.

While the swap fee for HXT is listed as zero, interest and fees for securities lending provide the required revenue. HXS bears a 0.30% fee. Investors should add this to an MER of 0.15% (0.45% total). The management expense ratio for HXT is 0.07%.

These two ETFs offer a particular advantage for taxable investors by providing the total return of the underlying indices, the S&P/TSX 60 (HXT) and the S&P 500 (HXS) respectively. No taxable distributions are involved, so capital compounds unfettered by tax.

Next-highest risk of losing money: Stupidity

Costs are inevitable, making it the highest risk. Stupidity is the second because even a stupid investor can actually get lucky once in a while.

Leveraged and inverse-leveraged ETFs have been categorized as appropriate only for intraday trading. This satisfies regulators and compliance departments. However, they can be used for much longer-term portfolios but not by dummies who don’t read the prospectuses, or who don’t bother estimating the volatility drag.

Otherwise intelligent people condemn these vehicles because the idea of compounding returns must conceptually elude them. Leveraged and inverse ETFs use synthetic structures that form a subset of ETFs with embedded strategies.

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