MONEY ETFs

Hot Money Flows into Energy and Bonds

Dollar sign in flames
iStock

Sometimes it pays to follow the crowd. At other times, you'll get burned.

All too often, I see investors heading in the wrong direction en masse. They buy stocks at the top of the market or bonds when interest rates are heading up.

Occasionally, though, active investors may be heading in the right direction. A case in point has been the flow of money into certain exchange-traded funds in the first half of this year.

Reflecting most hot money trends, billions of dollars moved because of headlines. The Energy Select SPDR ENERGY SELECT SECTOR SPDR ETF XLE -0.3778% exchange-traded fund, which I discussed three weeks ago, gathered more than $3 billion in assets in the first half, when crude oil prices climbed and demand for hydrocarbons remained high.

The Energy SPDR, which charges 0.16% for annual management expenses and holds Exxon Mobil EXXONMOBIL CORP. XOM -0.3932% , Chevron CHEVRON CORP. CVX -0.3574% , and Schlumberger SCHLUMBERGER LTD. SLB -0.4863% , has climbed 22% in the past 12 months, with nearly one-third of that gain coming in the three months through July 18. Long-term, this may be a solid holding as developing countries such as China and India demand more oil.

“We think the Energy Select SPDR is a play of oil prices remaining high and supporting growth for integrated oil & gas and exploration and production companies,” analysts from S&P Capital IQ said in a recent MarketScope Advisor newsletter.

Headlines also favored European stocks as represented by the Vanguard FTSE Developed Markets ETF VANGUARD TAX MANAG FTSE DEVELOPED MKTS ETF VEA -0.1411% , which holds leading eurozone stocks such as Nestle, Novartis NOVARTIS AG NVS -0.4937% , and Roche. The fund has been the top asset gatherer thus far this year, with $4 billion in new money, according to S&P Capital IQ.

As Europe continues to recover over the next few years and the European Central Bank keeps rates low, global investors will continue to benefit from this growing optimism.

The Vanguard fund has gained nearly 16% for the 12 months through July 18. It charges 0.09% in annual expenses and is a solid holding if you have little or no European exposure in your stock portfolio.

Rate Hikes

Not all hot money trends make sense, however. As the economy accelerates and interest-rate hikes look increasingly likely, investors are still piling money into bond funds, which lose money under those circumstances.

The iShares 7-10 Year Treasury Bond ETF , which holds middle-maturity U.S. Treasury bonds, continued to rank in the top 10 funds in terms of new money in the first half. The fund, which holds nearly $5 billion, is up nearly 4% for the 12 months through July 18, compared with 4.2% for the Barclays U.S. Aggregate Total return index, a benchmark for U.S. Treasuries. The fund charges 0.15% in annual expenses.

While investors were able to squeeze a bit more out of bond returns in the first half of this year, they may be living on borrowed time.

The U.S. Federal Reserve confirmed recently that it would be ending purchases of U.S. Treasury bonds and mortgage-backed securities in October. This stimulus program, known as “QE2,” has kept interest rates artificially low as the economy has had a chance to recover.

The phasing out of QE2 could be bearish for bond funds.

Will interest rates climb to reflect growing demand for credit and possibly higher inflation down the road? How will the ending of the Fed’s cheap money program affect U.S. and emerging markets shares?

Many pundits believe public corporations may pull back from their enthusiastic stock buybacks and trigger a correction. Yet low inflation and modest employment gains may mute bond market fears.

“The Fed is on track to complete tapering in the fourth quarter, and we think there is essentially no chance that it will move the fed funds rate higher this year,” Bob Doll, chief equity strategist with Nuveen Investments in Chicago, said in a recent newsletter.

“With the 10-year Treasury ending the quarter at 2.5%, the yield portion of this forecast is more uncertain,” Doll added, “although we expect yields will end the year higher than where they began.”

While there could be any number of wild cards spoiling the party for stocks, it is wise to ignore short-term trends and prepare for the eventual climb in interest rates.

That means staying away from bond funds with long average maturities along with vehicles like preferred stocks and high-yield bonds that are highly sensitive to interest rates.

Longer-term, shares of companies in consumer discretionary, materials and information technology businesses likely to benefit from a global economic resurgence will probably be a good bet.

Just keep in mind that the hot money can be wrong, so build a long-haul diversified portfolio that protects against the downside of a torrid trend going from hot to cold.

MONEY stocks

WATCH: What’s the Point of Investing?

In this installment of Tips from the Pros, financial advisers explain why you need to invest at all.

MONEY Portfolios

For $50 You Can Push For More Female CEOs — But Is It a Good Investment?

Indra Nooyi, chairman and chief executive officer of PepsiCo.
Indra Nooyi, chairman and chief executive officer of PepsiCo. Bloomberg—Bloomberg via Getty Images

Two new products let you invest in companies led by female executives. Whether this is a good idea depends on what you hope to achieve.

On Thursday, Barclays is launching a new index and exchange-traded note (WIL) that lets retail investors buy shares — at $50 a pop — of a basket of large U.S. companies led by women, including PepsiCoPEPSICO INC. PEP 0.0872% , IBMINTERNATIONAL BUSINESS MACHINES CORP. IBM 0.1414% , and XeroxXEROX CORP. XRX -1.6355% . This should be exciting news for anyone disappointed by the lack of women in top corporate roles.

After all, female CEOs still make up less than 5% of Fortune 500 chiefs and less than 17% of board members — despite earning 44% of master’s degrees in business and management.

The new ETN is not the only tool of its kind: This past June, former Bank of America executive Sallie Krawcheck opened an index fund tracking global companies with female leadership — and online brokerage Motif Investing currently offers a custom portfolio of shares in women-led companies.

The big question is whether this type of socially-conscious investing is valuable — either to investors or to the goal of increasing female corporate leadership. Is it wise to let your conscience dictate how you manage your savings? And assuming you care about gender representation in the corporate world, is there any evidence that these investments will actually lead to more diversity?

Here’s what experts and research suggest:

Getting better-than-average returns shouldn’t be your motivation. Beyond the promise of effecting social change, the Barclays and Pax indexes are marketed with the suggestion that woman-led companies tend to do better than peers. It’s true that some evidence shows businesses can benefit from female leadership, with correlations between more women in top positions and higher returns on equity, lower volatility, and market-beating returns.

But correlation isn’t causation, and other research suggests that when businesses appoint female leadership, it may be a sign that crisis is brewing — the so-called “glass cliff.” Yet another study finds that limiting your investments to socially-responsible companies comes with costs.

Taken together, the pros and cons of conscience-based investing seem generally to cancel each other out. “Our research shows socially responsible investments do no better or worse than the broader stock market,” says Morningstar fund analyst Robert Goldsborough. “Over time the ups and downs tend to even out.”

As always, fees should be a consideration. Even if the underlying companies in a fund are good investments, high fees can eat away at your returns. Krawcheck’s Pax Ellevate Global Women’s fund charges 0.99% — far more than the 0.30% fee for the Vanguard Total World Stock Index (VTWSX). Investing only in U.S. companies, the new Barclays ETN is cheaper, with 0.45% in expenses, though the comparable Vanguard S&P 500 ETF (VOO) charges only 0.05% — a difference that can add up over time:

image-29
Note: Projections based on current expenses and a $10,000 investment.

If supporting women is very important to you, you might consider investing in a broad, cheap index and using the money you saved on fees to invest directly in the best female-led companies — or you could simply donate to a non-profit supporting women’s causes.

If you still love this idea, that’s okay — just limit your exposure. There is an argument that supporting female leadership through investments could be more powerful than making a donation to a non-profit. The hope is that if enough investor cash flows to businesses led by women, “companies will take notice” and make more efforts to advance women in top positions, says Sue Meirs, Barclays COO for Equity and Funds Structured Markets Sales in the Americas. If investing in one of these indexes feels like the best way to support top-down gender diversity — and worth the cost — you could do worse than these industry-diversified offerings. “Investing as a social statement can be a fine thing,” says financial planner Sheryl Garrett, “though you don’t want to put all of your money toward a token investment.” Garrett suggests limiting your exposure to 10% of your overall portfolio.

MONEY stocks

7 Marijuana Stocks for a Buzzworthy (But Risky) Pot-folio

Agricultural Facility Recent Planting, Medical Marijuana Inc.

With marijuana legalization riding high, investors are looking for ways to play the trend. So far, though, even the biggest companies in this green rush have yet to turn a profit.

Earlier today, pot went on sale legally in Washington state for the first time ever, following in the footsteps of Colorado. A day earlier, New York became the 23rd state to permit the use of medical marijuana.

Throughout the country, marijuana legalization is going ganja-buster — leading many to wonder how they can profit from this trend.

Several private equity funds recently launched to invest in marijuana-related companies and startups, including one led by none other than the bobo bible, High Times magazine.

But what about retail investors? You’d think that the mutual fund and exchange-traded fund industries would have jumped on this green rush already. After all, there are specialty ETFs that let investors bet on such niche trends as fertilizer, fishing, and even water. But so far such an investment vehicle remains a pipe dream.

In the absence of a simple, off-the-shelf fund, investors can turn to individual equities. But be careful: Many stocks that are trying to ride the Pineapple Express are tiny micro-cap companies or penny stocks that are quite volatile and risky. Moreover, regulators have begun warning investors to watch out for pot-related “pump-and-dump” schemes, in which speculators talk up a stock and then sell before their inflated projections lose air.

In the Ganja universe, here are some of the biggest companies, based on market value, with their strategies and risks highlighted. Keep in mind that all of these “big” marijuana stocks are actually shares of tiny, still-profit-less companies.

GW Pharmaceuticals (Ticker: GWPH; share price: $92.60; market value: $1.4 billion)
Strategy: Cannabis-based pharmaceuticals. The company’s Sativex is already being used in several countries to treat spasticity related to multiple sclerosis. GW is also working on a treatment for severe childhood epilepsy based on cannabis extract.
YTD Performance: +132.3%
2013 Performance: N/A
2012 Performance: N/A
Profitable: No
Valuation: Price/sales ratio: 29.0 (S&P 500′s P/S ratio: 1.8)

Medbox (MDBX; $17.75; $537 million)
Strategy: Dispensary services. The company manufacturers self-service kiosks that dispense
medicines including marijuana.
YTD Performance: —0.3%
2013 Performance: —70.1%
2012 Performance: +4,819.4%
Profitable: No
Valuation: Price/sales ratio: 77.5

Cannavest (CANV; $11.37 $381 million)
Strategy: Makes and markets cannabis related products, including hemp oil.
YTD Performance: —60.0%
2013 Performance: +470.0%
2012 Performance: +150.0%
Profitable: No
Valuation: Price/sales ratio: 44.8

Advanced Cannabis Solutions (CANN; $7.50; $101 million)
Strategy: Leases growing space and related facilities to licensed marijuana business operators.
YTD Performance: +138.5%
2013 Performance: +221.8%
2012 Performance: —99.0%
Profitable: No
Valuation: Price/sales ratio: N/A

Medical Marijuana (MJNA; $0.20; $105 million)
Strategy: A holding company with diversified businesses ranging from consumer products to services, including security and surveillance for cannabis-related businesses.
YTD Performance: +27.1%
2013 Performance: +53.5%
2012 Performance: +512.1%
Profitable: No
Valuation: Price/sales ratio: N/A

GrowLife (PHOT; $0.10; $81 million)
Strategy: A marijuana equipment maker that sells hydroponic gardening gear.
YTD Performance: —27.8%
2013 Performance: +308.1%
2012 Performance: —75.3%
Profitable: No
Valuation: Price/sales ratio: 11.4

Cannabis Sativa (CBDS; $6.40; $75 million)
Strategy: The former sun-tanning company is pushing into the marijuana industry, producing cannabis-based oils and edibles. Its new CEO is Gary Johnson, the former Libertarian Party presidential candidate and a two-term governor of New Mexico.
YTD Performance: +990.0%
2013 Performance: —11.0%
2012 Performance: +12.4%
Profitable: No
Valuation: Price/sales ratio: 1000.0

MONEY Ask the Expert

Can I Diversify My Portfolio With One ETF Rather than Four?

Q: Does investing in a “total stock market index fund” give you diversified exposure to large-, medium-, and small-sized companies? Or do I need to invest in separate mutual funds for my large- and small-company stocks? — Toby, Davis Junction, IL

A: No, you don’t need separate funds. The Vanguard Total Stock Market ETF VANGUARD INDEX FDS TOTAL STOCK MARKET ETF VTI -0.3503% is designed to give you exposure to a broad cross-section of different types of domestic equities in a single exchange-traded fund.

Its portfolio breaks down like this: around 72% is invested in large companies, a little less than 20% is in medium-sized businesses, about 6% is in small-company shares, and 3% is in so-called micro-cap stocks.

Now, you can achieve similar diversification by allocating your dollars into a collection of more narrowly constructed funds that focus on industry-leading large companies or quick-growing but volatile small companies.

For instance, you could pick up Money 50 funds Schwab S&P 500 Index SCHWAB CAPITAL TST S&P 500IDX SEL SWPPX 0.0319% , with iShares Core S&P Mid-Cap ISHARES TRUST REG. SHS S&P MIDCAP 400 IDX ON IJH -0.3822% and iShares Core S&P Small Cap ISHARES TRUST CORE S&P SMALL-CAP ETF IJR -0.7868% . (Although, if you’re not careful, you might end up with more exposure to smaller companies than you want. About 30% of IJR’s portfolio is in micro-cap stocks.)

All things being equal, says BKD Wealth Advisors’ portfolio manager Nick Withrow, you’re better off going with the one fund than three or four.

For one thing, each fund comes with its own expenses. If VTI dovetails with your risk tolerance, then you’ve taken care of your domestic stock portfolio at a measly cost of 0.05% of assets annually. That’s marginally cheaper, by about 0.06 percentage points, than buying a host of exchange-traded funds that collectively approximate VTI’s portfolio, says Withrow.

But there’s another reason — you.

Basically, you don’t want to get into the business of buying and selling ETFs to try and time the market. And you’re much less likely to get into that expensive habit if you buy-and-hold one fund, rather than picking three or four.

“The more choices an investor has, the more apt he or she is to feel that they have to do something,” says Withrow. “The idea of simplicity, especially with a buy-and-hold attitude, goes a long way.”

Of course, one total market exchange-traded fund doesn’t mean your portfolio is complete. Don’t forget about foreign equities or, you know, bonds. But when it comes to U.S. stocks, one cheap total market ETF (like VTI) is particularly useful.

MONEY ETFs

As BlackRock Goes to War With Vanguard, Mom-and-Pop ETF Investors Win

Even with $1 trillion in exchange-traded fund assets, BlackRock is being forced to slash costs on ETFs to compete with low-cost leader Vanguard.

Even as BlackRock is set to amass $1 trillion in exchange-traded fund assets in its iShares business, U.S. retail investors increasingly prefer to send their money to low-cost leader Vanguard.

With $998 billion in ETF money, BlackRock has more than the next contenders, Vanguard and State Street, combined.

But the company has struggled to compete with Vanguard, known for its investor-friendly low-cost investing, for mom and pop’s nest eggs. Retail investors now account for more than half of the $1.8 trillion in ETF assets under management in the U.S, according to consulting firm PwC.

So far this year, Vanguard has pulled in about $30.3 billion in net new ETF money in the U.S., or about 43% of the market, while iShares is second with $24.7 billion, or about 35%.

That reflects a trend that’s been going on for years: At the end of 2009, BlackRock had 47.7% of total U.S. ETF assets under management, compared with 11.7% for Vanguard. By the end of May, BlackRock’s market share was down to 38.9%, compared with 20.6% for Vanguard, according to Lipper.

“Our aspiration is to be number one in flows, and we can’t get there without being higher in the retail market place,” said Mark Wiedman, the BlackRock executive who heads the iShares business globally, speaking at the company’s annual meeting in New York in June. “We are starting to change our voice for that audience and I would say historically we frankly haven’t done that good a job.”

The market share loss comes in spite of BlackRock’s two-year effort to win retail investors.

BlackRock introduced a line of low-cost “buy and hold” investor-aimed ETFs in 2012, and since then has been cutting the fees on its ETFs, revamping its sales team, and pushing a new branding campaign. The firm has cut expenses on 12 funds since 2012, ranging from its S&P Total U.S. Stock Market ETF then to its high-dividend ETF in June 2014.

BlackRock says its flows have improved since it started its new retail effort.

One of the most significant price reductions was in its iShares High Dividend ETF. The cost to investors for that fund dropped to 0.12% of assets a year from 0.40%, a move that would cost BlackRock $11.2 million annually, based on the $4 billion in the fund. Last quarter, iShares ETFs generated some $765 million in base fees revenue.

“Every basis point that you cut a fee impacts revenues, but we don’t really look at that — we look at the profitability of our ETF business over the long term,” BlackRock executive Frank Porcelli, head of U.S. Wealth Advisory Business, said at Reuters’ Global Wealth Management Summit in June.

Asked about how fee cuts would affect BlackRock’s profits, he said it was “not relevant.”

With $4.4 trillion in total assets among its various product lines, BlackRock remains the world’s largest asset manager and is unlikely to be eclipsed by Vanguard anytime soon.

BlackRock has nearly tripled the size of the iShares business since it bought it from Barclays five years ago, largely by selling to big institutions, such as the Arizona State Retirement System, which plunked down $300 million to seed three iShares funds last year. It has also won institutional and retail investors abroad; BlackRock has a strong presence in Europe, Asia, Canada and Latin America. Total BlackRock ETF assets outside of the U.S. are about $280.5 billion, about 36 percent of the $700 billion total market.

Analysts say that iShares’ size and scale makes the effect of fee cuts in the near-term fairly minimal on the overall business, but that a prolonged price war could hurt the firm.

“It’s a tough spot to be in,” said Edward Jones analyst Jim Shanahan. “There is some growth potential there, but it is slow to materialize and it has to be powerful enough to offset the addition of a lot of these products with fees less than the current weighted average fee rate.”

Vanguard, which unlike BlackRock isn’t publicly traded, offers significantly cheaper funds. The average expense ratio of a Vanguard ETF is 0.14%, or $14 for every $10,000 invested, compared with the industry average of 0.58%. BlackRock’s average expense ratio is 0.32%.

“When talking about large, commoditized ETFs, low cost makes a big difference, and Vanguard is a little bit more competitive,” said Gabelli & Co analyst Macrae Sykes.

“Investors recognize Vanguard as the low-cost leader — whether for index funds, for active funds, for bond funds, for money market funds, or for ETFs,” said Vanguard spokesman David Hoffman. “We like to say that we’ve been lowering the cost and complexity of investing for 38 years. We are also increasingly being recognized for our commitment to providing high-quality products that can play an enduring role in a portfolio.”

MONEY Markets

The Real Reason You Should Care About Insider Trading

Martha Stewart leaving court after conviction
Businesswoman Martha Stewart, 62 leaves federal court in New York City on March 5, 2004. Stewart was found guilty on all counts over a suspicious stock sale. Jeff Christensen—Reuters

A new study suggests insider trading is even more rampant than anyone thought. But it's not so obvious why individuals should be concerned.

Between Michael Lewis’s takedown of high-frequency traders in Flash Boys and a new study finding that one in four M&A deals are preceded by insider trading, Wall Street’s public image is looking more “sell” than “buy” these days.

But how much does insider trading actually harm the average Joe? Even if Gordon Gekkos are running amok, do cheaters pose a real threat to those who play by the rules? The answer might surprise you.

1. Insider trading won’t hurt you if you don’t trade. Just like front-running high-frequency traders, those who trade on secret information are unlikely to hurt the portfolios of buy-and-hold investors, says Rick Ferri, founder of Portfolio Solutions.

In theory, an individual who frequently trades could be unlucky and end up buying or selling just as market-riggers are doing the opposite. But holding a diversified portfolio of stocks over long periods of time dilutes that damage; if you hold an index fund for a decade, you’d likely lose no more than pennies from trading inequities, says Ferri. “Getting upset about insider trading is like getting upset about the NFL draft,” says Ferri. “It makes for juicy headlines, but unless you’re a professional, it’s not really going to affect you.”

2. Insider trading could even help you. The presence of cheaters in the market could, coincidentally, benefit uninformed investors who just happen to land on the right side of a trade, says Santa Clara University finance professor Meir Statman, who has studied investor perceptions of insider trading. Let’s say you need to sell a stock in a company to free up cash, says Statman: If that happens to coincide with an insider trading-driven run-up before the company announces a merger or acquisition, you could actually win out.

3. Nevertheless, these cheaters are destroying the American Dream. Pundits have used the points above to argue that insider trading should be legalized. But the so-called “victimless crime” claims at least one victim, says Statman: confidence in the market. “A belief in fair play is part of good American culture,” says Statman. “The stock market is supposed to be an emblem of the American Dream: the belief that if you work hard and do your research, you’ll be rewarded. It’s not supposed to feel like the lottery.”

In his research, Statman has found that people living in economies riddled with more corruption, like India and Italy, are twice as likely as Americans to deem insider trading acceptable.

insider
Meir Statman, “Is It Fair? Perceptions of Fair Investment Behavior across Countries,” Journal of Investment Consulting, 2011.

There are a few key takeaways: If we want to keep our markets fair, it’s important that cheaters are caught and punished. But news headlines shouldn’t prevent you from investing, as long as you do it wisely — with diversified index funds and minimal trading. “Trading is like going into the jungle,” says Statman.

“There will always be beasts who are larger than you and thus able to devour you,” he says. “So go in as rarely as possible.”

MONEY ETFs

The ETFs You Should Never Buy

Leveraged funds that amplify the market's returns can quickly—and unpredictably— magnify risks in your portfolio.

Larry Fink, the CEO of giant asset manager BlackRock, said at a recent investment conference that a kind of exchange-traded fund called leveraged ETFs “have a structural problem that could blow up the whole industry one day.”

BlackRock runs iShares, a leading ETF manager. ETFs are funds that can be traded like stocks, and they are great, low-cost tools for investing in indexes such as the S&P 500. Leveraged ETF also tracks indexes, but add the twist of magnifying gains or losses. So, for example a “2x” leveraged ETF might aim to deliver twice the return, up or down, of the S&P 500.

iShares does not run leveraged ETFs. So you can discount Fink’s remarks as at least partly a broadside against the competition. He was also arguing that regulators should focus on specific products, rather than on the size of a money manager — a good point to make when you run $4 trillion, as BlackRock does.

It’s unclear exactly what system-wide risk Fink is saying such funds pose. That said, this much is true: For individual investors, leveraged ETFs are a no good, terrible, very bad idea.

The key thing about leveraged ETFs is that they deliver their leverage on a daily basis. You might assume that if, say, the market falls 5% in a year, a 2X leveraged fund might lose 10%, and if the market rises 5%, the 2x fund would gain 10%. But in fact the returns could be quite different over time, especially in a volatile up-and-down market.

Fund companies that sell leveraged ETF’s disclose this, but the effect of daily leverage is a subtle point some individual investors looking for a more aggressive investment might miss. The Securities and Exchange Commission, by way of cautioning investors, provides an example of how this works, which we’ve turned into charts.

Start with a big down day in the markets. One ETF just follows the market index, while another delivers twice the gain or loss. The effect is predictable:

image-2

The next day, the market goes back up. The regular fund rises 10%, and the levered fund rises 20%.

image(14)

Both funds did what they were supposed to do each day. But look what happens when you add up the effects of two days of trading.

image(12)

The index lost $1, but your twice leverage fund lost four times as much.

Daily leverage can be useful to professional investors. Other forms of leverage can be useful to individuals with long-run goals. But few individual investors are likely to be successful with the kind of short-term market timing these funds are built for.

MONEY Warren Buffett

One Weird Trick That Will Help You Beat the Market Like Warren

140530_HOME_Buffett_1
Warren Buffett Ben Baker—Redux

Here's a no-brainer way to win with "Warren" stocks. It won't do you any good now, but it would have been brilliant in 1993.

My story, Inside Buffett’s Brain, is about the search by financial economists and money managers for persistent patterns in stock returns. Some of these patterns might help to explain why a handful of money managers, including Buffett, have done so well. The story is about more than Buffett, though. The hunt through past market data for potentially winning strategies is a big business, and has fueled the growth of exchange-traded funds (ETFs). So a word of warning is in order.

Here’s the result of astoundingly simple Buffett-cloning strategy I put together, inspired by a “modest proposal” from Vanguard’s Joel Dickson. All you have to do buy stocks with tickers beginning with the letters in “Warren.” (You have double up on the “r” stocks, natch.)

Winning with Warren NEW

This likely “works” in part because it’s an equal-weight index—meaning each stock in the W.A.R.R.E.N. portfolio is held in the same proportion. Traditional indexes like the S&P 500 are “capitalization weighted,” meaning they give more weight to the biggest companies in the market. Because smaller stocks have outperformed in recent years, equally weighted indexes have done pretty well compared to traditional indexes in the period in question.

So you might find out that you can also beat the market with an equally weighted basket of stocks whose tickers begin with the letters in your name too. Just cross your fingers and hope the trend doesn’t reverse in favor of blue chips.

Another reason why this trick worked is that it picks from among current S&P 500 names, which means the stocks on the list are already in a sense known winners. Companies that used to be small and then graduated to the S&P 500 are on list, and companies that used to be big and then got small or disappeared aren’t on the list. But you couldn’t know which companies those were in 1993.

This is obviously dopey, and no way to run your money. (And the ideas I wrote about are much, much more sophisticated than this.) But there’s a serious point here. ETFs are a great way to buy cheap, reliable exposure to the stock market. But these days most ETFs track not a simple well-known benchmark, but a custom index built upon rules which, if followed, are thought to give investors an edge. For example there are indexes which tilt toward companies with better-than-average sales, or which specialize in certain sectors or investment themes.

These indexes often have really impressive past performance. In theory. Based on “back tests” of market data, from before the index was actually in operation.

And of course they do. Today indexes are often created with an ETF launch in mind. So there’s not much point in building an index and marketing it if you don’t know that the strategy has already won. Unfortunately, knowing what’s already worked in the past doesn’t mean you know what will work in the future.

In fact, investors in new indexes are likely to be disappointed. Samuel Lee, an ETF strategist at Morningstar, explains that in any group of past winning strategies, a high number will have won just through sheer luck. The future average performance of those strategies is almost certain to decay. Because luck runs out.

MONEY Markets

Frontier Markets Are Hot: Don’t Get Burned

Spectacular skyline at night, Dubai Marina, Dubai, United Arab Emirates, Middle East
The skyline of Dubai Marina in the United Arab Emirates, whose growth has helped propel the "frontier" markets. Novarc Images; Alamy

Frontier markets stocks have blown past their counterparts in the emerging and developed worlds this year. Here are three cautions before you go chasing them.

Tiny countries are big right now. The MSCI Frontier Markets Index, which tracks companies based in small but rapidly growing economies like Kenya and Vietnam, has returned more than 15% year-to-date. That’s compared to only 2% for the slightly more developed emerging markets and 4% for the S&P 500. Performance like that might make an ETF like iShares MSCI Frontier 100 — one of the most liquid and diversified frontier options out there — look attractive to investors today.

FM Chart

FM data by YCharts

But remember that appearances can be deceiving. A big reason frontier markets indices have done so well recently is the fact that MSCI is “graduating” the booming markets Qatar and the United Arab Emirates to emerging market status this month, and that’s led to a “technical” (or herd-driven) rally, says Morningstar analyst Patricia Oey. While it’s true that those countries have benefited from a strong property market and rising infrastructure spending, investors trying to get ahead of the index change are also a major factor in the ETF’s hot performance.

So before you march out and buy up shares in frontier markets stocks or funds, consider these three cautions.

1. It is hard to be truly “diversified” with current frontier markets offerings. Once Qatar and the U.A.E. are gone, the biggest countries in the MSCI Frontier 100 will be Kuwait and Nigeria, and those two alone will make up 40% of the index. Though new rules will make the index slightly broader than in the past (under old methodology, that top-two concentration would be 53%), the way countries are weighted could leave you disproportionately exposed to a single market. Other ETFs, like EGShares Beyond BRICs, offer a greater geographic span, with 75% in emerging markets and 25% in frontiers, but come with less in-county diversification: Some nations are represented by a single stock.

2. They can rack up big taxes. Normally ETFs don’t throw off big capital gains, but in this case you need to watch out, says RegentAtlantic director of research Andy Kapyrin. That’s because the MSCI change means ETFs tracking the index will have to unload the Qatar and U.A.E. portions of their portfolios, which have gained as much as 80% in the past year. You’re protected from these taxes on gains if you hold the ETF in a tax-advantaged account like your 401(k), but given the limits on diversification, you probably don’t want more than 1% or 2% of your retirement savings in this type of investment, says Kapyrin.

3. They are risky. Although you’d expect frontier markets to be riskier than emerging markets — since the underlying countries are, by definition, less developed — the two market types actually have similar levels of volatility. That’s because stocks in the frontier markets are less correlated to one another than emerging markets equities, says Oey. For example, it’s less likely that problems in Pakistan correlate with those in Jamaica, but more likely that the Russian and Chinese markets will experience bumps at the same time, as they’re further along in their development. That said, frontier markets are still extremely vulnerable during global downturns. See below how much harder hit than U.S. stocks an older index of frontier markets stocks — Guggenheim Frontier Markets — was during the last financial crisis.

^SPX Chart

^SPX data by YCharts

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