Are exchange-traded funds dangerous?

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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.

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.

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.”