Three ETFs I Wouldn’t Feed To My Dog

by on June 27, 2011 | ETFs Mentioned:

As the size of the ETF lineup has ballooned to nearly 1,300 products, there has been some criticism over the increased granularity and sophistication that is characteristic of many of the latest additions.¬† Many of the ETPs that have hit the market over the last few years probably have very little appeal to the vast majority of investors–especially those with a long-term focus. The iPath S&P 500 VIX Short Term Futures ETN (VXX), which has lost about 80% of its value over the last year, is one product that most investors shouldn’t go anywhere near. The structure of the futures markets–including steep contango at the short end of the curve–means that this ETN is almost guaranteed to lose money over the long run.

VXX is a poor fit for most investors, but it can be a very powerful tool for those looking to establish short-term exposure to volatility. It’s a fine product designed for a very specific type of investor, and offers an efficient way to establish exposure to a specific asset class. The same could be said for most leveraged ETFs; they’re not for everybody (and in fact are inappropriate for many investors), but can be very powerful tools when used correctly. I think of many of the more sophisticated ETPs on the market as chainsaws; they’re not very useful for slicing a morning bagel, but can be tremendously helpful when trying to cut down a tree.

Many ETPs are of limited interest to most of the investing public, appealing only to a specific demographic. But then there are those products that are, for lack of a better term, worthless. Some ETPs simply don’t make sense under any scenario, and seemingly don’t belong in any portfolio–long-term or short-term. Below, we outline three ETPs that the industry could do without [sign up for the free ETF newsletter]:

ELEMENTS  Dow Jones High Yield Select 10 ETN (DOD)

This exchange-traded note consists of a subset of the Dow Jones Industrial Average, one of the most widely followed equity indexes in the world. The methodology is relatively simple; the 30 stocks in the DJIA are ranked by annual dividend yield, and the ten highest yielding securities are selected to make up the index to which DOD is linked.

The strategy may have obvious appeal to investors looking to focus on blue chip stocks with juicy dividend yields. But the methodology is so basic and the underlying portfolio so limited that there’s no need to wrap the strategy up in an ETN wrapper that introduces credit risk into the equation and charges investors 75 basis points annually–likely more than enough to offset any dividend enhancement generated. The same exposure could be constructed in about ten minutes without an annual management fee; if you’re interested in the “Dogs of the Dow” strategy, you’d be better off simply buying the component stocks.

For those seeking a dividend strategy, there are plenty of better options out there offering access to more advanced and complex strategies [see 25 Dividend ETFs With Attractive Yields].

iPath Seasonal Natural Gas ETN (DCNG)

Investors seeking exposure to natural gas through a futures-based strategy have no shortage of options. UNG invests in front month contracts, rolling exposure as the underlying approach maturity. UNL spreads its holdings across 12 months, limiting the “roll” process to a fraction of the portfolio. And NAGS spreads exposure equally across four different contracts, a strategy designed to minimize the impact of contango.

And then there’s DCNG, an ETN from iPath that seeks to replicate the Barclays Capital Natural Gas Seasonal TR Index. That benchmark consists of a single exchange traded futures contract expiring in December. The portfolio is rolled once per year as expiration approaches, with assets shifting into December of the following year.

Again, there’s potentially a lot to like about the underlying methodology. Investors seeking exposure to natural gas without the potentially adverse impact of rolling holdings in contangoed markets might find the exposure offered by DCNG quite appealing. But if that’s the case, there is a way to establish that exposure without paying 0.75% in annual fees or adding the credit risk that comes along with any ETN investment: simply buy the natural gas futures contract.

Investors must possess the required approvals and be establishing a position equal to a minimum size; those without both of those might see DCNG as a useful tool But there’s little value added by a product that rolls exposure once annually; the low frequency of trades makes DCNG of limited usefulness to any investor seeking natural gas exposure [Commodity ETF Investing: Five Factors To Consider].

B2B Internet HOLDRS (BHH)

Given all the quirky construction methodologies, expense calculations, and concentration issues, it wouldn’t be all that difficult to make a case that any of the HOLDRS products should be included on this list. But BHH is one of the most bizarre components of the ETP lineup, and is about as useful as a screen door on a submarine.

Some ETPs are more diversified than others. At one end of the spectrum are funds like the Russell 3000 Index Fund or Wilshire 5000 ETF that include thousands of individual components. At the other end is BHH, whose portfolio consists of exactly two stocks: Ariba (ARBA) and Internet Capital Group (ICGE). Moreover, ARBA accounts for more than 90% of assets, essentially making this product the equivalent of a single stock, and making the language from the prospectus comical: “B2B Internet HOLDRS are designed to allow you to diversify your investment in the B2B segment of the Internet industry through a single, exchange-listed instrument representing your undivided beneficial ownership of the underlying securities.”

The difference, of course, is that single stocks don’t come with expense ratios, whereas BHH does. The Bank of New York, the trustee and custodian for BHH, charges a quarterly custody fee of $2 for each round lot of 100 B2B Internet HOLDRS. At the current price of about $1 per share, that works out to a quarterly expense ratio of about 2%, or 8% annually. The portion of the fee that exceeds dividends paid is waived, so the actual fee isn’t quite that steep. In fact, neither component company has paid a dividend in recent years, so those who hold BHH are effectively paying nothing. Still, it’s hard to fathom a scenario in which BHH would be useful–unless of course you’re looking for creative ways to pull off some insider trading.

Disclosure: No positions at time of writing, photo is courtesy of John Haslam.