What to look for in high yield ETF investments and how to spot the hidden risks

ETFs, or exchange traded funds, started out as a discount alternative to mutual funds. The costs of investing in an ETF are much lower than costs associated with a conventional mutual fund, plus early ETFs focused on simpler goals.

Instead of picking and trading investments, operators of early ETFs managed investors’ money “passively,” with the goal of duplicating the performance of a market index. This let the operator charge an MER (management expense ratio) of as little as 0.1%, compared to an average MER on conventional mutual funds of 2.6%.

ETFs can cut the cost of investing, but they can lead you to balloon your risk. For instance, ETFs trade on stock exchanges, just like stocks. So, you can buy or sell, or sell them short, any time the market is open. In contrast, you can only buy or sell a mutual fund at the end of the day, and you can’t sell a mutual fund short. If you take advantage of this liquidity to trade in and out of ETFs—or to sell them short—you can wind up losing money, or making less than you would by simply holding on to the top ETFs.

In addition to higher MERs, those ETF innovations brought added fees not counted in MERs, plus added risk. In or out of an ETF, however, these strategies may produce meager returns, or lead to losses.

Unfortunately, rather than helping investors make more money, ETFs may spur them to act on their own trend-following or theme-investing urges. This is called “top-down investing.” It essentially involves investing on predictions, by making what you might call side bets on market or interest-rate trends, currency spreads, industry bubbles and so on.

Most investors are far better off with “bottom-up investing.” That’s where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy diversified, balanced selection of stocks that appeal to you as individual, prosperous businesses.

ETFs are one of the most benign investment innovations in modern financial history. But it’s a mistake to let low fees lure you into questionable investments, even when seeking high yield ETF investments.

High yield ETF investments can expose you to a lot of risk.

These days, some investors searching for income are looking at high yield ETF investments—and taking on a lot more risk than expected in many cases.

The selling proposition of a high yield ETF is that you can make a lot of money by diversifying across risky asset groups. However, those assets usually include high-yield bonds, and in some cases emerging market debt.

We think bonds in general are unlikely to perform as well in the next few years as they have in the past, mainly because interest rates will likely hold steady or rise. (Bond prices and interest rates are inversely linked. When interest rates go up, bond prices go down, and vice versa.) That means the fund would only earn interest income on its bonds; and instead of capital gains, those bond holdings could produce capital losses.

We are even less enthusiastic about high yield ETF investments in high-yield (“junk”) corporate bonds. In corporate bonds, high yields often signal danger rather than a bargain. They put you at risk of capital losses, as bond prices can fall along with the share price of the underlying issuer. That’s the same for high yield ETF holdings in emerging market debt.

Bonus tip: our recommendations for finding the best ETF investments

• Determine if the ETFs you buy will include capital gains distributions.
• Know how broad the ETF is, so you can determine its volatility. The broader the ETF, the less volatility it may have. A sector-based ETF, like one that tracks resource stocks, may be more volatile.
• Know the liquidity of ETFs you invest in.
• Know the economic stability of countries when investing in international ETFs. It’s also worth mentioning that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments.
• Consider buying ETFs in a lump sum rather than periodic small amounts to cut down on brokerage fees.

High yield ETFs hold the allure of making more money, but at the cost of security. Have you fallen for the promise of profits only to find it didn’t work out? What did you learn from the experience?

Lots of new ETFs have come to the market since the popularity of ETF investing has grown. Many of these new ETFs have higher MERs than traditional ETFs, yet they are still cheaper than mutual funds. But do you take into account the added risks?