A longstanding advantage of mutual funds and exchange-traded funds (ETFs) is the ease of getting exposure to various types of assets and investments. Even individual investors with small amounts of wealth can get exposure to foreign markets, commercial real estate and diversified bond portfolios with little effort. ETFs are also being increasingly used by advisers for their tax efficiency and ease of providing exposure to various investments.

At the same time, some mutual funds and ETFs offer the potential for a wrecking ball swinging inside your portfolio. This risk also exists with individual securities, be they stocks, bonds, publicly traded partnerships, etc. The bigger danger with funds is the potential to perceive them as safer simply because they are a mutual fund or ETF. A fund comprising high-risk investments is a risky fund.

The latest example of a risky asset being placed into a fund wrapper is bitcoin. Last month, the U.S. Securities and Exchange Commission (SEC) approved the first-ever spot bitcoin ETFs. The 11 ETFs to get the green light are designed to directly track the prevailing market (“spot”) price of bitcoin. Previous cryptocurrency ETFs provided indirect exposure via trusts or futures.

This was not a decision the SEC came to lightly. The agency had increasingly found itself under pressure to approve spot bitcoin ETFs after denying applications for such funds over the course of many years. In the accelerated approval issued last month, the SEC cited a U.S. Court of Appeals ruling against its prior denial of a Grayscale application for a spot bitcoin ETF among its reasons for changing course. The court opined that the SEC had failed to adequately explain its reasoning for denying Grayscale’s application.

Proponents of bitcoin ETFs say the new funds will make it easier for investors to get exposure to bitcoin and will reduce the chances of fraud occurring. Stricter rules and procedures have been put in place to avoid the vacuum that Sam Bankman-Fried and others tried to operate in. Proponents also argue that bitcoin provides additional diversification benefits to portfolios.

Among the opponent’s arguments are that bitcoin is highly speculative. It was created out of thin air in January 2009 and has experienced a very high level of volatility since the latter half of the 2010s. Putting bitcoin into an ETF wrapper changes none of this. When a high-risk asset is placed into an ETF or something similar, it remains a high-risk asset. The only things changing about bitcoin are that it will be easier and cheaper to trade and will be offered through a more regulated structure.

This is hardly the first time we’ve seen high-risk funds created, and it certainly won’t be the last. Single-stock ETFs were launched in 2022. As the name implies, they provide leveraged exposure to a single stock, like Tesla Inc. (TSLA), and allow you to speculate on a stock’s near-term upside or downside. Various leveraged and inverse ETFs and mutual funds have also been in existence, with some imploding.

There is a very long and not very positive history of thematic funds. Those of you who were investing during the dot-com bubble of the late 1990s may remember the Munder NetNet fund. This mutual fund rode the dot-com bubble up and then crashed down along with it.

The lesson for investors seeking to use mutual funds or ETFs is to always start with broad-based investment themes. Funds tracking a well-known stock index and a well-known investment-grade bond index plus cash equivalents—e.g., short-term Treasury bills, money market funds, etc.—are the default option. You can modify this allocation by including preferences for value, growth, dividend income, smaller companies, international exposure—and seeking broad-based funds for each type.

Only after settling on the right mix of more traditional types of investments should speculative whims be considered.

Mutual Fund and ETF Tools for AAII Members

AAII members have access to a variety of tools to find and analyze funds on AAII.com. In addition to our expanded guides, there are evaluators, compare tools and the A+ Investor Grades. You can also track funds with My Portfolio and discuss them in the Mutual Funds & ETFs community. These tools and more are included in your AAII membership; all you have to do is go to AAII.com to take advantage of them.

Wishing you prosperity,

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