Over the past decade Exchange Traded Funds, otherwise known as ETFs, have become one of the most popular forms of investing. According to the Investment Company Institute, as of December 31, 2014, 1,411 Exchange Traded Funds held $1.974 trillion worth of assets or 13% of total net assets managed by long-term mutual funds, ETFs, closed-end funds and unit investment trusts. In fact, over the past five years alone, $772 billion has gone into ETfs while traditional mutual funds have had net inflows of just $81 billion.
For the scope of this column, ETFs can be defined as securities that in many ways act like a mutual fund, as they have the ability to group securities together such as stocks, bonds, commodities or a pool of assets like an index fund. However, they differ materially from mutual funds as they trade like a stock, being bought and sold during the day in addition to the fact that the price of the ETF changes throughout the day. Although ETFs have become popular and are very appropriate for many circumstances, they also have pitfalls that can negatively impact average investors if they are not careful.
The ease at which ETFs can be traded is perhaps their biggest attraction. As noted above, they can be bought anytime throughout the day and, unlike mutual funds which are only priced at the close of every business day, can be sold short. Unfortunately, these qualities make them extremely tempting for investors to trade too often. Ironically, what makes ETfs attractive doubles as their Achilles’ heel. For example, a retail investor listens to a talking head on CNBC blather on about how to benefit from unrest in the Middle East. He/she then immediately logs on to the computer to short an ETF that invests only in Middle Eastern Countries, only to be subsequently whipsawed. The fact of the matter is that usually when you hear something on the news or read an item in the newspaper or on the computer, the professionals already know about it and the price of that Exchange Traded Fund already reflects this information.
Along with providing broad market exposure, investing in ETFs presents the opportunity to invest in ways that only a few have the knowledge, information and experience to invest. When investing in ETFs (or anything else for that matter) it’s important to do the appropriate amount of research prior to jumping in and following a “hot trend”.
Sector investing is another attractive feature of Exchange Traded Funds. However this can also set your portfolio back if you’re not careful. For certain, diversification is a positive, powerful discipline that helps investors achieve their goals. However, through the use of ETFs an investor could go from 0% invested in a particular sector to “all in” at any time throughout the day. Investors can go from not invested at all to having a significant amount of their portfolio in a specific sector very quickly, done without giving much thought to the risks. If you have an ETF based portfolio, maintain your sector diversification. Be careful not to get over-weighted. Ease your way into a sector with ETFs as you would using individual securities.
Lower costs are also a reason why ETFs are enticing. ETFs typically have much lower expense ratios than mutual funds. However, be aware of the commissions that comes with buying ETFs. If you buy and sell ETFs frequently, the $8 or so cost of trading can add up quickly. That said, Charles Schwab, TD Ameritrade and many other brokerage firms have over 100 ETFs available for purchase, many that are commission free. Be sure to look at the list of commission free ETFs that your broker provides before making an investment.
Using ETFs is an attractive way to invest. In many ways they are fundamentally sound investments. However, they also can appeal to our compulsive side, which can potentially derail performance. Be sure to recognize both the positive and negative features of ETFs and don’t fall prey to their pitfalls, by doing your research before investing. Don’t jump into the ETF game too FAST!
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial adviser. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial adviser prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.