First, most people may have heard of ETFs but they don’t really know what they are. ETFs (Exchange Traded Funds) or ETPs (Exchange Traded Products) have actually been around since the 1990’s but their popularity has soared in the last several years. ETFs are investment products that allow investors to buy an entire “bucket” of stocks through a single security which tracks and coincides with the returns of a stock market index. Bought and sold on the exchange like stocks, ETFs hold assets that usually consist of stocks, commodities, and bonds and trade at prices that closely match their underlying assets.
ETFs are an attractive investment vehicle to investors because they are designed to mimic index investing, but without the fees, complications and risks associated with mutual funds. ETFs may actually track and be based on the major indexes, but for the most part, they perform like a stock, with their price values fluctuating throughout the day. They are also a less expensive investment product without management fees, commissions or penalty fees. Their annual expenses usually run in just the 0.1% – 0.7% range.
A fund manager steers this ship and submits to the SEC a detailed plan of how the fund will operate in order to receive permission to proceed. Once that permission is received, shares are created. Unlike stocks, the Authorized Participant (AP) has the ability to create shares on demand. The AP creates units or shares in the primary market by adding a bucket of securities that is equal to the current holdings of the ETF. A block of shares is then officially created, usually equaling about 50,000 shares, which then becomes available for trading on the secondary market. The process also works in reverse if someone wants to sell shares.
That said, these funds are a bit tricky to maneuver, so a little forethought and preparation can help. Ian Naismith, portfolio manager with Sarasota Capital Strategies, Inc. in Osprey, Florida, is an ETF fan, but generally for sophisticated investors. Novice investors can make serious missteps when it comes to ETFs, so he strongly recommends proper research before joining the ETF fray.
With more than 1,000 ETFs out there to choose from, and rising interest among investment firms and consumers, Naismith wouldn’t be surprised if the number grew to 1,600 – 1,800 this time next year.
Even experienced investors need to read the ETF fine print as the fund offerings have grown. Some brokers have taken to adding extensive disclaimers on their websites to ensure potential investors are forewarned about the more exotic offerings, such as leveraged and inverse ETFs. Keep in mind that these complex ETFs can cost more, have a higher risk and be less tax-efficient than traditional ones. These specialized ETFs have sparked concerns with the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission.
Investors with long-term perspectives should be wary as these products trade and reset each day, and a fund’s performance could skew away from the performance of the underlying index or benchmark.
Brenda P. Wenning, founder of Wenning Investments, LLC in Newton, Mass., is a practitioner of “active investment management” as a way to forestall portfolio dips. Wenning says that she and many like-minded investment managers have gravitated toward ETFs, particularly as the offerings have become more diverse. She emphasized the need for proper investment advice when considering such funds.
Where novice investors can misstep, Sarasota Capital’s Naismith cautions, is by plunging into ETFs solo and then tackling multiple trades. “It takes a lot of discipline to manage a portfolio well. Those without much money can get too reactive because they get too nervous.” While ETFs can be attractive investment vehicles, Naismith says that those who get jittery during market swings might be better served with a slice of a well-managed mutual fund (preferably with a fund manager who has proven performance through rising or ebbing markets alike).
WHAT DOES THIS MEAN FOR YOU? Although ETFs are surging in popularity, their unique features and more complex offerings require due diligence and careful management by an average investor. Understand the different assets that make up a particular ETF, understand how it is trading, and do your homework so that you are comfortable with the manager that will be handling it. It’s a good idea to know the captain’s sailing record before you get on his ship!