The pros and cons of Exchange-Traded Funds

Apr 10, 2012

Exchange-Traded Funds (ETFs) are a popular alternative to mutual funds.

Are they right for you? 

On this week's Money Matters, financial commentator Greg Heberlein tells KPLU's Dave Meyer that a well diversified ETF can be a great investment.

Exchanged-traded funds, known as ETFs, were launched in 1992 to track the Standard & Poor’s 500 stock-index. They were nicknamed Spiders. The investor advantage was that although they mimicked mutual funds, they could be traded during market hours, not after the markets closed.

In 2008, ETFs were approved for wider uses than a broad index. So today, although mutual funds still have 10 times more assets than ETFs, the ETF market has grown to more than a thousand choices and more than $1 trillion in assets.

What does Greg think?

Broadly diversified ETFs, ones investing in hundreds or thousands of stocks, look safe. Bill Schultheis, author of The Coffehouse Investor and a huge fan of buying stock index funds, says broadly diversified ETFs are sound instruments for the individual.

But Schultheis and the legendary John Bogle, who invented the index fund decades ago, agree that buying specialty ETFs can be a dangerous proposition. Investing in a narrow purpose mutual fund (for example, a fund that only invests in coal companies) is the reverse of diversification. The same is true for ETFs.

ETFs have a tax advantage. 

Since gains are reinvested, the account can grow while taxes are deferred. Most ETFs charge individuals less to get in than mutual funds.

But investors need to pay attention here. Besides a low-entrance fee, ETFs can pass along costs for purchasing the stocks or commodities within the ETF. Paying outside managers, an ever more popular technique for ETFs, also can build up the costs. And sometimes, ETFs have a spread between what the holdings cost and what the ETFs charge investors.

One special area of concern is ETFs investing in foreign stock indexes. Studies have shown the largest ETF variance in true price occurs when trying to match foreign indexes.

Greg gets nervous over any investment strategy that hasn’t been tested over a long period of time.

So with ETFs, one at least has to consider the downside. Most ETF owners are short-termers. If they start selling, it can catch the individual investor off guard and accentuate a downturn before they can react.

The safety of ETFs has been questioned on another front. 

Some EFTs targeting overseas stocks and indexes use speculative derivative contracts. The derivative market has exploded to more than $700 trillion. Some believe that if the market moves suddenly, certain derivatives could unravel, accentuating the loss.

John Bogle says ETFs often encourage the bulk of the investment community to chase fads, last week’s or last year’s best gainers. That’s true across the investment industry. But he fears that as publicity of ETFs gets even hotter, less sophisticated participants will abandon the long-term index approach.

So here’s the bottom line:

If you are tantalized by this increasingly popular strategy, go with the ETFs reflecting hundreds or thousands of stocks or bonds. 

Diversification is the key to success.

As John Bogle likes to say, a stock or an investment manager can outperform the general market for a relatively short period of time, but almost never over long periods.