Our content is reader-supported and may contain affiliate links. Purchases from our links earn us commissions at no cost to you. Learn more.
On my blog, I often talk about ETFs and which ones to invest in. But, what about ETFs to avoid? In this post, let’s do exactly that. Before I proceed with the list of ETFs to avoid, I want to point out one main criterion that I use.
A given fund must be suitable for risk-conscious long-term investors. Otherwise, it should be avoided for the purposes of this analysis. I also look at the entire ETF category and see if there are better alternatives out there. Okay, with that aside, let’s delve in.
Avoid Older Covered Call ETFs (JEPQ, JEPI, QYLD)
The first set of ETFs to avoid are the older generation of covered call funds. The ones I am talking about are the likes of JEPI, JEPQ, QYLD or XYLD. There is a new generation of covered call funds like SPYI, GPIQ or QQQI. With these funds, there is very little reason to hold JEPI, JEPQ or QYLD.
Why is that? JEPI and JEPQ are not doing a very good job of mitigating net asset value (NAV) erosion risk. NAV erosion entails declining net asset value per share for a fund. Because NAV/share and a stock price are equivalent most of the time, NAV erosion means declining stock prices.
The main culprit for NAV erosion risk for older covered call funds is their inflexible covered call overlay. Funds like QYLD or JEPI go heavy on selling call options without a sensible regard for market conditions. For this reason, the upside capture for the older generation of covered call funds is lower. In other words, when Nasdaq-100 or the S&P 500 rallies, funds like JEPI or JEPQ will capture a smaller upside.
Many investors put their money into JEPI or JEPQ to generate above-average yields. But, with NAV erosion risk being high, distributions don’t grow by as much for these funds relative to their peers. And, that’s a big problem especially in retirement. Stagnating or slow-growing distributions can result in degrading income adjusted for inflation. The new generation of covered call funds from Neos and Goldman Sachs are much more superior.
For instance, let’s look at performance since the April tariff plunge episode.
Neos and Goldman Sachs funds are roughly up. But, JEPI stock price is slower to recover. Neos and Goldmand Sachs take a nuanced approach to their covered call overlay. Thus, my take is that they are superior products for income-focused investors long-term.
Steer Clear of Single Stock Covered Call ETFs
Here is another set of products that long-term risk-conscious investors should steer clear of. These are single stock covered call funds. The most popular products in this class are by YieldMax. YieldMax popularized single issuer funds with income overlay. Among them are MSTY, PLTY and TSLY. YieldMax invests in these stocks either directly or via synthetic positions. Then, it takes covered call positions for income. YieldMax also uses credit spreads to mitigate NAV erosion for these funds.
I don’t have anything against these products per se. As any investment vehicle, they do have their own place under some circumstances. But, as far as their suitability for long-term investors, that’s a different matter. Single issuer ETFs lag their underlying stocks. If someone buys let’s say PLTY ETF, that means that he is bullish on Palantir by design. Then, buying Palantir stock and selling shares for self-distribution is a superior approach.
PLTY, MSTY and many others don’t protect investors from downside and they cap upside in a big way. That may not sound like a very good deal. Since its inception, PLTY lagged PLTR by almost twofold. The picture is similar for MSTY, TSLY or APLY.
Also, these aggressive covered call funds are not tax-efficient in taxable accounts. Let’s take PLTY. When PLTR rallied in 2024, most of PLTY distributions got taxed as ordinary income in 2024.
But, what if PLTR stock tanks? That’s not a good outcome either. PLTY would go down and nobody wants their investment to drop.
Also, most PLTY distributions would be a bad return of capital. True, return of capital distributions don’t get taxed until cost basis is zero. With YieldMax ETFs it is a matter of one or two very bad years for the underlying stock. After that, everything will get taxed as ordinary income.
But, what if NAV of a fund declines? This has been the case for many underperforming Yieldmax Funds. These returns of capital become unattractive distributions. The fund is just giving you your money back. That’s what we observe with YieldMax ETFs that go heavy on selling options.
Things get worse since YieldMax single stock funds use synthetic positions. These synthetic positions have to be rolled over on a regular basis. Most of the time, these synthetic positions expire in less than a year. By rolling them over, YieldMax realizes gains or losses non-stop. By law, most ETFs must distribute at least 90% of their realized income. In the YieldMax case, these distributions get taxed as ordinary income in a taxable account. That’s not tax efficient either.
Avoid Leveraged ETFs (TQQQ, NVDL)
The other funds that long-term investors should avoid are leveraged ETFs. These ETFs promise 2x or 3x daily returns based on a certain benchmark. This benchmark can be either a broad based index like Nasdaq-100 or a single stock like Nvidia. The catch for these funds are in their name.
Let’s take TQQQ ETF which gives investors 3x daily returns of Nasdaq-100. It is true that the daily performance will be almost always close to 3x. But, the long-term performance will never be. In directional markets, the leverage either balloons the fund’s assets or reduces them to nothing. Nasdaq-100 may recover after a sharp downturn. But, TQQQ may have to scrape the bottom of the barrel for a very long time.
If we look at returns for TQQQ ETF since inception, they are indeed massive.
The outperformance is staggering. The trick is that TQQQ began trading in 2010 right after the Great Financial crisis. If TQQQ got its start in 2007, this picture would have looked totally different.
Anyway, we may get the impression that TQQQ is a very good deal. But, let’s zoom in on the 2021-2023 period. As you may know, Nasdaq-100 declined since its 2021 peak by over 30%. If you bought TQQQ in the second half of 2021, your return in 2022 would have been over -70%. And, while Nasdaq-100 recovered in 2023, TQQQ languished in the red until 2024.
This will be generally true for any quick bear market episode. When the underlying drops by a double-digit percent, leveraged ETFs will struggle. In fact, if the drop is sequential and quick enough, the loss of capital can be permanent. Or, the recovery will be years in the making at best.
- Get better ideas, better research tools
- Learn to manage your portfolio
- In-depth analysis of ETFs
- 24/7 stock coverage
- Quant stock ratings
The left tail of returns distribution for leveraged ETFs is very fat. In other words, positive returns are more frequent. But, it takes only one precipitous bear episode to wipe out all prior gains.
Of course, 3x leveraged ETFs are some of the worst. 2x leveraged ETFs are arguably better but still bear that risk of a sudden wipe-out.
These funds may have their place for tactical short-term trading, perhaps. But, if I were a long-term investor, I would say stay away from these funds. Slow and steady is better than quick riches that can evaporate any day.
Avoid Active ETFs Investing in Risky Stocks
Other ETF traps I steer clear of as a long-term investor includes active funds that invest in risky assets. They are not that hard to spot. Let’s examine one by ARK called ARKK managed by Cathie Woods and her team. ARKK takes concentrated positions in high risk, high growth stocks. The fund holds sizable allocations in mid-, small- and even micro-cap stocks. Yep, even those companies with a few hundred millions in market cap.
The fund is active. As you may know, many active funds in the US tend to fail to beat their benchmark. For instance, take the S&P 500. Close to 90% of large-cap funds lagged behind the S&P 500 over the last 15 years. I linked a video explaining why this is so.
But, let’s come back to ARKK. With active funds, a lot depends on the management. If management loses its touch or bad decisions follow, then forget it.
In fact, if I were a long-term investor, I would stay away from active funds as much as I can. With passive index funds, I know exactly what I am getting into. The selection process is transparent and most importantly consistent year in year out. That’s usually not the case with active funds, and there are very few exceptions, if at all.
Cathie Woods and Her ARKK Active ETF Example
ARKK is probably an extreme example of an active fund. This ETF makes bold bets on AI, biotechnology and robotics stocks. The problem is that it is easier said than done when it comes to discerning winners from losers. Cathie Woods takes a long-term view on her bets. This has worked sometimes, but sometimes it produced spectacular flops. High conviction can turn into a liability quickly.
Take Teladoc Health company. It is a telemedicine and virtual healthcare company. It used to be very popular among investors at the peak of Covid pandemic. Cathie Woods took a big bet on this stock. At some point in 2021, ARK funds collectively owned over 10% of all Teladoc’s outstanding stock. But, as pandemic recovery ensued, Teladoc’s growth sputtered. Instead of scaling out, ARK doubled down on Teladoc. The stock continued declining until losing over 80% of its value by 2024. That’s when Cathie Woods threw in a towel and sold its last Teladoc share at a huge loss.
If we compare ARKK to Nasdaq-100, there were periods of outperformance. But, underperformance has overwhelmed the fund. This shows how stock picking is so hard to execute on a consistent basis.
Why QQQ ETF May Not Be Perfect For Growth Exposure
And, my final fund is not necessary to stay away from, but the thing about is QQQ that it tracks Nasdaq-100. This one probably comes as a surprise for some of my long-time readers. When I started this blog, I recommended Nasdaq-100 as a way to ride the growth wave.
But, here is what to keep in mind. If you are looking for a pure-play growth exposure, QQQ just happens to be so. The problem is with its design. Nasdaq-100 only includes stocks trading on Nasdaq. Because of only 100 names, QQQ often takes concentrated positions in certain stocks.
QQQ did well thanks to a high concentration in Magnificent 7 and other growth names. But, for an investor interested in growth, there are arguably better constructed funds. Some of them can give a more consistent exposure to growth across the entire US stock market. One fund that I personally invest in is SCHG by Schwab. But, there are others of course. There is nothing wrong with QQQ or QQQM, as long as you are aware of their limitations. They can be terrific for growth exposure.
And that’s all I have for ETFs to avoid. Do you have a fund to avoid of your own? Drop a comment and let me know.