Why Your Fancy, New ETF Might Be Too Fancy
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Here's your money briefing for Thursday, January 16th. I'm Arianna Espuru for The Wall Street Journal. Investors put more than $1 trillion into U.S.-based exchange-traded funds, or ETFs, last year. And no wonder. They're cheap, liquid, and tax-efficient. But lately, Wall Street has been using ETFs to package various financial products that are increasingly obscure and complex.

As ETFs get more complicated, knowing whether they're attractive to you or whether you're the right person to use them or how to use them gets extremely difficult. So what do you need to know about these new, fancier kinds of ETFs? We'll talk to Wall Street Journal Heard on the Street columnist John Sindreo after the break.

ETFs have been pretty good investments, but they might be getting too good. Wall Street Journal Heard on the Street columnist John Sindreo joins me.

John, let's do a quick refresher first. What is an ETF and how does it differ from other investments? So an ETF is a bit like an open-ended mutual fund, but they're far more beloved by investors because an ETF is backed by a bank or what's called an authorized participant that provides it with constant liquidity. The shares tried in exchanges so you can buy and sell them during the day. They're very tax efficient because of the way that this redemption in kind works.

So essentially, they are the biggest story in financial markets in the past couple of decades. And in 2024, they surpassed $1 trillion in total inflows in the US. And so they're the biggest story in financial markets in the past couple of decades.

when the rest of Wall Street is now trying to find other ways to profit from ETFs. So they're trying to package even pretty complicated products into ETF form because it's just what everybody wants these days. You mentioned that record that ETFs broke last year, surpassing $1 trillion. Is that why they're so popular? Explain to me the draw that people have towards them. It's tax efficient. It's liquid. And it's also, by virtue of all these things, it's a cheap product. It's a cheap vehicle. You pay...

lower fees on ETFs that you do on comparable funds. A big part of the whole passive investing rush of the past couple of decades has to do with ETFs, even though ETFs are now branching into many other things. So there's active ETFs, there's ETFs that invest in complex derivatives, there's ETFs that are starting to invest in private markets. So everything is now coming in ETF form. In your story, you highlight a number of ETFs that look great, but haven't delivered on what they promised.

What's causing this? Well, there's a variety of potential issues that you could highlight once you start venturing outside of these very vanilla S&P 500 or Stocks Europe trackers. And I would argue

argue that they all share in common that complexity makes things harder and more unpredictable. As ETFs get more complicated, knowing whether they're attractive to you or whether you're the right person to use them or how to use them gets extremely difficult. And

In some cases, for example, we are even having ETFs that are promising to match returns of other assets in a tax-efficient way. And this might work out, but you also don't know what the IRS is going to say a few years down the line. You don't know whether they structure this correctly or whether you're going to get a tax bill down the line. So...

Again, a lot more small print that needs to be read and a lot more unknowns that will clear themselves out in the near future. And as these ETFs become more complex in the coming years, what are some of the concerns that investors have?

much of the concern about them has to do with liquidity. That is the typical concern that has been thrown around whenever you mention ETFs. Essentially, the assets underlying these ETFs are getting more illiquid because, well, providers want to broaden investor access to these assets.

And there is the fear that at some point this is not going to go well. It must be said, so far, these fears have proven unfounded. Like we had in 2020, for example, a situation because of the COVID crisis in which the corporate debt market completely froze and ETFs remained very liquid. Actually, people kept trading the ETFs even as the underlying assets were not really moving. For these ETFs,

ETFs that are outwardly so complicated and complex, who are they for? That's the key question. And many people can always argue that there is the right buyer for every product, and they're probably right. So for example, for a single name leverage ETF, there's probably some professional that really

really has a trade to place that specific day and makes a lot of money from it. And this is a cheap, easy way to do this. But at the same time, you're not getting the upside from owning stocks and it's pretty tax inefficient. And if the market really slides, you're going to lose a lot of money. So my point of view is that the investor base for this should be pretty small. Yet,

It exists. There is a profile, but I just don't think it's commensurable to how popular they are. I think that is the crucial question when it comes to the role that these products serve in the market.

For investors who want to put money into ETFs or who might be attracted to the name, what research should they do beforehand to better understand these pros and cons that we're talking about? You always hope that ideally everybody will read the fine print and that therefore some of the pitfalls that are highlighted in this piece will not be as problematic as you might think, because it's true. Most people do their due diligence.

But I think we have to be realistic. Like, very often people buy stuff they don't really understand. That's just the way of markets. And the more complicated you get it, the more that it's likely that people will do this. And of course, we also go into the issue of the more leeway these ETFs have to make.

pursue different strategies, the less that what says on the label will be understood by this very mass market audience that ETFs are directed to. What's the best way to measure an ETF's actual performance? Let's say for the everyday person, everyday investor, what are some things they can look at to better understand what they can get from this ETF? Always take into account the post-fee performance.

If the ETF revolution was about something, it was about lowering fees. Even if you're not getting a return above the market or you're not promised any return above the market and you know you're always going to be slightly below the index, you're doing far better after fees.

always look at the right benchmark for what you're investing in. Is it how well dividend stocks did last year? Then you can compare an ETF that gives you income with that. Is it how well bonds did last year? You can look at all these things, but always keep in mind that

If it's a very high fee, it may not fit into what you need, because even if you believe that this particular strategy is perfect for your situation, it may be that you're better served with a less bespoke, more vanilla, but lower costing product. That's WSJ Heard on the Street columnist John Sindereo. And that's it for your Money Briefing. This episode is produced by Jess Jupiter with supervising producer Melanie Roy.

I'm Arianna Espuru for The Wall Street Journal. Thanks for listening.