investing

Are exchange-traded funds dangerous?

Transparency. ETF disclosure is daily, says Gabriel, whereas mutual fund disclosures are quarterly. Fund holdings can be easily found on Morningstar's website.

Low expenses. Expenses for ETFs are about 0.27 percent, while they average 0.64 percent for index mutual funds, according to Morningstar. Lydon says one reason ETFs are popular is because 70 percent to 80 percent of all actively managed funds underperformed their benchmarks in the last 10 years.

Diversification. Because ETFs replicate an index, they offer easy diversification. For example, an ETF may own 50 real estate investment trusts, or REITs. "You've diversified away market risks," Gabriel says.

Tax efficiency. ETFs tend to be highly tax efficient. "Because of their structure, ETFs have a low history of capital gain distribution," Archard says.

Drawbacks of ETFs

A bewildering array of ETFs. With more than 1,000 ETFs on the market, choosing the right ETF takes more due diligence than ever. "Not everything is suitable," Gabriel says. "You need to understand what you own. People let research end with the name of the fund. That can get you into lots of trouble." For example, some ETFs are leveraged, meaning they invest with borrowed money, which makes them more risky. "Fund performance can be the opposite of what investors expect," Gabriel says.

Commission costs. Many ETFs require you to pay a brokerage commission. That cost can eat into returns. "If cost is a factor, expense ratios are just one component," says Archard. "If you want to dollar cost average like in mutual funds, you may incur brokerage commissions," says Anthony Rochte, who co-heads the intermediary business group at State Street Global Advisors, which offers 92 ETFs. Some firms, such as Schwab, Fidelity and Vanguard, have waived commissions for at least some of their ETF offerings.

High volatility. Small-sector ETFs are another thorny area. "Sectors are getting thinner and thinner," says Lydon. "And some of these are riskier than others." For example, there's now a small cap Brazilian ETF. "There are only a handful of stocks in the index," he says. "What happens if one of those companies has lousy earnings?" The answer: a big drop in price.

"Specializing in a sector can get you killed," says Jack Colombo, editor of Closed End Fund & ETF Report. "They can be profitable or a disaster."

Archard counsels investors to know their portfolio goals, including tax and income considerations. "That leads you to (smart) allocation decisions," he says.

Rochte believes that ETFs give investors a sharper tool to build a portfolio. "But that doesn't mean there's less risk," he says. "Couple choice and precision with good sound advice -- that's very powerful."

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