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Are exchange-traded funds dangerous?

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Highlights
  • Most ETFs mirror a broad market index and are sold on an exchange.
  • ETFs trade like stocks -- nearly in real time -- and are tax efficient.
  • Though expenses on ETFs are low, many require you to pay a commission.

Exchange-traded funds, or ETFs, are investors' newfound darlings.

They've poured around $1 trillion into the investments. And every possible sector is covered -- including equity, fixed income and commodities -- among the 1,000-plus ETFs available.

Most exchange-traded funds mirror a broadly diversified index such as the Standard & Poor's 500. This collection of securities is bundled and then sold on an exchange. Essentially, an ETF is a mutual fund that trades like a stock, says John Gabriel, ETF strategist at Morningstar. "(Investors) can buy a full sector at one shot," he says. "It's a pretty simple concept."

ETFs come with risk

But with ETFs' popularity comes more risk as newer launches, such as leveraged or inverse ETFs, seek out more exotic territory. And sector funds are getting riskier too; there's even an ETF based on nanotechnology.

"As the market grows, there are lots of launches," says Noel Archard, head of U.S. product at iShares, which offers more than 200 ETFs. "More than half were launched in the last two or three years. Investors need to get a handle on what's out there."

That means shifting through more "noise," he says.

Exchange-traded funds are efficient, so much so that investors are increasingly trading them. And that can lead to a phenomenon like the so-called May 6th "flash crash," when the Dow dropped nearly 1,000 points within 15 minutes, and one out of four ETFs fell 60 percent or more, according to The Wall Street Journal.

"ETFs lend themselves to electronic trading," Gabriel says. "We had this period of chaos, when all those automated orders hit."

Tom Lydon, editor of ETF Trends, says, "Some 70 percent of the trades that were canceled were ETFs because they weren't accurately priced. Stop-loss orders were hit." Roughly 45 percent of exchange volume in general comes from ETFs, he says.

Despite this glitch, exchange-traded funds are largely safe. "The flash crash was a wake-up call," Lydon says. "We'll see new rules implemented. ETFs weren't the cause, they were the victim." The bigger risk comes from leveraged and inverse ETFs, he says.

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In an effort to prevent another flash crash in the future, the Securities and Exchange Commission recently approved the adoption of new stock-trading circuit breakers and extended them to nearly 350 ETFs as well as all the stocks in the Russell 1000 Index. In June, the SEC approved a circuit breaker pilot program to stocks listed in the S&P 500. Here's how it works: A 10 percent price change in a security within a five-minute period triggers the circuit breaker, which halts trading in that security for five minutes, giving "the markets an opportunity to attract new trading interest in an affected stock, establish a reasonable market price and resume trading in a fair and orderly fashion," according to the SEC.

Exchange-traded funds offer many advantages over mutual funds -- and a few drawbacks.

Pros of ETFs

Liquidity. Because they trade like stocks, ETFs can be easily sold nearly in real time. Conversely, mutual funds bear a net asset value, or NAV, that's priced after the market closes for the day. ETFs rarely trade at a discount, says Lydon.

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