November 15, 2011 in Investing

Should I invest in ETFs?

Exchange-traded funds, or ETFs, have been around since 1993, but in the past few years they’ve been winning over individual investors in a big way.

Because most ETFs are passively managed, an ETF is essentially an index fund that trades like a stock. There are now more than 1,000 ETFs to choose from in the U.S marketplace, according to the Investment Company Institute, and investors are jumping on the ETF bandwagon in droves. But should you?

Start by considering what kind of investor you are, says Lule Demmissie, managing director of investment products and retirement at TDAmeritrade. ETFs — the garden-variety index trackers that make up the vast majority of the offerings — appeal to investors who prefer funds that track indexes rather than actively managed mutual funds.

ETFs can also appeal to investors who want to play different sectors of the market and fill gaps in their diversified portfolios, says Demmissie. They now include almost every flavor, from ETFs that track bonds, real estate, commodities and currencies to niche offerings that can be country specific, socially responsible, or dividend- or fundamentals-weighted.

“What investors love about ETFs is they offer diversification, low cost and trading flexibility,” says Michael Iachini, managing director of ETF Research at Charles Schwab Investment Advisory. “Stock and bond ETFs, the plain vanilla index-based funds, are pretty straightforward and are really not very different from mutual funds. They are extremely transparent, you can see what they hold, they are very well understood, and I think that investors are pretty comfortable with them.”

But before you invest in ETFs, consider these key questions.

What does the ETF try to do?

“Some investors say, ‘I want to buy ETFs. What ETFs have done well?’ That is not the right way to approach it,” says Iachini. “What you should do is say, ‘OK, I want an ETF that buys small-cap stocks,’ and then find out what ETFs pull that kind of stock.”

Understand the investment goal of the ETF and how it is structured, he says. “Is it an index ETF? Most ETFs are, but there are some that are actively managed, so make sure you understand that. If it is an index, how is the index built? Is it a traditional market-capitalization-weighted index? Or equal-weighted, or fundamentals-weighted?”

An ETF’s investment goal and underlying holdings can typically be found on the fund’s website, updated daily, as well as historical returns and performance comparisons to the index.

What does the ETF cost?

While index mutual funds generally have low management fees, ETFs often have the edge, with operating expense ratios averaging 0.56 percent of assets compared to 0.98 percent for index mutual funds, according to Morningstar. The U.S.’ first and still most popular ETF out there, State Street’s SPDR S&P 500, costs just 0.09 percent. But investors need to consider total costs, which include trading fees.

ETFs often carry a commission upon buying and selling, so they may not make sense for investors who add to positions in small increments, as many people do in retirement funds or through dollar-cost averaging. However, a growing number of brokerages now offer commission-free ETFs, making them attractive even in these situations.

Investors also need to be cognizant of bid-and-ask spreads. “That little gap is a trading cost to you. You have to make sure that gap is narrow,” says Iachini, who recommends using limit orders.

What is the track record of the ETF?

An ETF may not trade as close to an index as an index mutual fund. This is called a tracking error, and you want that number as small as possible, says Iachini. “If a portfolio is too small, it might be hard for the ETF manager to fully replicate the index.”

Also look at whether the price matches the net asset value.

“Generally speaking, ETFs tend to trade very close to their net asset value — that is one of the nice features of them. But that doesn’t always hold, and it tends to break down a little bit whenever the underlying securities in the ETF become really hard to trade,” says Iachini, citing high-yield bond funds during the credit crisis of 2008 as an example.

In evaluating a fund, investors can see the ETF price compared to net asset value on the previous market day. Depending on the tools they have available, it’s possible to see it intraday through the Intraday Indicative Value.

One way to hedge against these risks is to choose funds with at least $20 million in assets, though more is better, Iachini says.

What about other risks?

Sector ETFs, such as commodities, currencies and country-specific ETFs, come with their own unique set of risks that individual investors should understand before plunging in. But what about all the scary media reports about ETF risks? “Concerns about ETFs are often overblown, but not in every case. There are certain reasons investors should pause, especially with exotic ETFs,” says Iachini.

Exotics would be leveraged and inverse ETFs, which are designed to invest using borrowed money or move in the opposite direction of the market. They have attracted warnings from the Securities and Exchange Commission, the North American Securities Administrators Association, or NASAA, and a host of international agencies. “These exotic ETFs are beyond the ability of mom-and-pops to evaluate or hold,” David Massey, president of the NASAA, told USA Today in June.

Fortunately, with the surge in ETFs has also come a deluge of investor education. Schwab, TDAmeritrade, BlackRock, State Street and Vanguard have loaded up their websites with analyses and tools. Large research firms such as Standard & Poor’s and Morningstar, the fund watcher, are ramping up ETF coverage, as are specialized firms like IndexUniverse.

“Risk itself is not the enemy, it’s just making sure you understand … on the other side of risk is also opportunity. Every investment has an element of both,” says Demmissie. “It’s all about making sure clients educate themselves (about ETFs) and go into an investment with eyes wide open.”

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