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The boom in exchange-traded funds ran smack into the implosion of the global financial markets.
There are now 721 ETFs with $478 billion in assets, according to the Investment Company Institute. Although that's more than three times as many funds as three years ago, and new ETFs continue to debut, their total assets decreased 16 percent in the past 12 months.
Poor results of stock indexes and sectors that a majority of ETFs are built to mirror have had a chilling effect. After all, no investor wants to mirror disaster. A number of funds were liquidated or their introductions were postponed until the markets show signs of improvement.
The top performers in the ETF pack have been those that shortedor bet againsttheir particular index or sector, as well as those that focused entirely on Treasuries. For example, Proshares UltraShort Technology (REW) rose 63 percent over the past 12 months, and the iShares Barclays 20-plus Year Treasury Bond (TLT) was up 36 percent.
"I think we're in for a bit of a pause in the ETF industry in which we're going to see some consolidation among the funds," says Scott Burns, director of ETF analysis for Morningstar Inc. in Chicago. "In addition, some of the weaker offerings that didn't really whet investor appetites will close."
Holding baskets of stocks or bonds as mutual funds do, ETFs replicate market indexes or sectors and have a goal of low-cost diversification. Traded on an exchange, they can be bought and sold during market hours, unlike a mutual fund in which you trade shares at the end of the day.
Important factors behind the ETF boom are that their annual fees generally are lower than those of mutual funds, and their tax efficiency generally is greater. That makes them superior for investing a large amount at once, but doesn't work quite as well with gradual investment.
"ETFs are not as effective if you're trying to dollar-cost average into the market for a specific amount each month," says Jim Ross, senior managing director for State Street Global Advisors, in Boston. "Whenever you're buying and selling an ETF you create some kind of commission, so small trades do make ETFs a little more expensive."
While the myriad ETF specialties could prove daunting to an investor assembling a portfolio, it is a basic strength of the vehicle.
"The overall state of the ETF industry is a lot better than the state of the traditional mutual fund industry, in the sense the number of offerings is increasing and providing more opportunities for investors to diversify their portfolios," says Ron DeLegge, editor of ETFguide.com, in San Diego. "ETFs can be bought in flavors not available in traditional mutual funds, such as commodities, gold, currency, and real estate."
The best ways to use ETFs, Burns says, are for a passive asset-allocation strategy in which you buy broad indexes in domestic and international stocks, bonds, and commodities and as substitutes for stock picking to avoid risking your money on one or two stocks.
"We like the health-care sector in 2009 because, despite a rough global recession, people will still use health care," Burns says. "Financials are cheap and, although we're not buying right now, if we did it would be an ETF higher up in the capital structure."
Burns recommends these ETFs:
iShares S&P Global Healthcare (IXJ), which has two-thirds of its portfolio invested in large pharmaceutical companies from around the world.
PowerShares Financial Preferred (PGF), with a solid 13 percent dividend yield, is a preferred-stock ETF taxed like a common stock.
"ETFs are low-cost, fully transparent in their holdings, and you can buy or sell them all day so you trade on your own timeline," Ross says. "For the first quarter of 2009, I'd say large-cap core equities are down so much that, if you have the stomach for volatility, it might be time to enter the market."
Ross likes what he calls "couch potato funds" for investors who just want a market presence:
SPDR MSCI ACWI (CWI), holding stocks of the world except the U.S., has half of its holdings in the United Kingdom and Europe.
SPDR Dow Jones Wilshire Total Market (TMW), which includes the entire U.S. market, is a good broad-based bet if you fully expect the market to come back.
"Consumers aren't doing what they're supposed to be doingconsumingbut an ETF that is a defensive play in companies such as Procter & Gamble, General Mills, and Kraft Foods does make sense," says DeLegge. "Utilities and health care are other defensive industry sectors that do well even during tough times and tight consumer spending."
DeLegge suggests these choices:
Consumer Staples Select Sector SPDR (XLP) focuses on mature consumer staples companies that aren't overly dependent on a strong economy.
Utilities Select Sector SPDR (XLU) has a concentrated portfolio of 31 utilities and low turnover.
Health Care Select Sector (XLV) owns leading North American health-care companies that have plenty of cash.
As far as the recent performance of ETFs, it is a result of the actual markets rather than of the investment vehicle. "Like I said, there's an ETF for every kind of investing philosophy," concludes Ross.