Another one bites the dust.
Just when investors thought the exchange-traded fund was the absolutely perfect investment to diversify their portfolios, it turns out it can carry risks just like other vehicles.
A number of ETFs, which are mutual funds traded on a stock exchange throughout the trading day, have been hammered on sudden market downturns. Rather than performing like diversified indexes, they tumbled like individual stocks.
This behavior doesn't mean ETFs have suddenly turned evil, but rather that some investors have chosen inappropriate ETFs for their goals.
ETFs are increasingly popular because they charge lower fees than traditional mutual funds and offer access to wide swaths of the market.
They can be bought for the cost of a trading commission, with some major firms such as Vanguard and Fidelity even offering commission-free trades on some ETFs.
All of that is undeniably positive. Yet some ETFs are indexes of small and volatile universes such as single countries or commodities; their easy access may lead to reckless trading; and investors sometimes chase past returns rather than study up on what they're actually buying.
Here are warnings from experts about taking a good thing too far:
"Just because an ETF is a passive, low-cost investment doesn't mean there's little or no risk," says Paul Justice, director of ETF research for Morningstar Inc., in Chicago. "An ETF that invests in Brazilian small-cap companies still has plenty of risk."
"Some investors shoot and ask questions later," says Ron DeLegge, editor of ETFguide.com, in San Diego. "They don't know what should be in their portfolios, so they buy ETFs without a game plan."
"Too often, individual investors are just looking for the hot tipsomething exciting and sexy that will do well in the short term," says Mark Salzinger, editor of The Investor's ETF Report, in Brentwood, Tenn. "The fact that ETFs are so easy to trade can lead to people over-trading them."
Even an ETF's name can confuse an investor. An example from Justice is United States Oil ETF (USO), which has declined 13 percent in value the past 12 months. It doesn't actually own stock in oil companies, but rather crude oil futures contracts that can be extremely volatile.
At best, it should be considered as a small "satellite" holding rather than a broad bet on the oil industry, he says.
"There has been a trend toward more concentrated ETFs that focus on sectors, commodities, countries, or regions, and you just won't get the same diversification in a narrow sector ETF that you'd get in a broad-market fund," says DeLegge. "Some single-country ETFs, especially in emerging markets, are the worst offenders because they can be concentrated in a handful of stocks."
As investors have learned the hard way, in turbulent markets the prices of some ETFs can turn unpredictable quite suddenly, no matter what the value of their underlying portfolios. ETFs can trade substantially above or below their net asset value.
To obtain broad-market exposure and inexpensively diversify your overall portfolio, you should first select broad-market ETFs, the experts agree.
A solid foundation for an individual's diversified portfolio would be Vanguard Total Stock Market ETF (VTI) or SPDR Dow Jones Total Market ETF (TMW), each of which covers U.S. stocks. For an international holding, Vanguard FTSE All-World ETF (VEU) encompasses the world excluding the U.S.
For a small-cap portfolio, there is Vanguard Small-Cap Value ETF (VBR) or iShares Russell 2000 Index ETF (IWM). For utilities, an example is Utilities Select Sector SPDR ETF (XLU), and in health care there's Health Care Select Sector SPDR (XLV).
"One ETF that's been doing well all year is Industrial Select Sector SPDR (XLI), which has held up pretty well even though the S&P is down," says DeLegge. "Another possible ETF strategy is to overweight the better-performing sectors."
Once you've laid the foundation, ETFs also permit sophisticated investors to try out their personal strategies.
So, if you believe European stocks will head further downward, look at ProShares UltraShort MSCI Europe (EPV), which shorts the MSCI Europe index, DeLegge says. Or, if you think the Euro currency is going up and the worst is over, the CurrencyShares Euro Trust (FXE) is long the euro and short the U.S. dollar, he adds.
Avoid overlap in the ETFs in which you invest. For example, DeLegge has seen investors buy three large-cap ETFs with no real reason to own all three of them.
ETFs generally are better for stocks than for bonds, Salzinger believes, because an ETF index structure is harder to construct with bonds.
There are many different types of bonds, some liquid and frequently traded while others are less liquid. That means an actively-traded bond portfolio you'd find in a traditional mutual fund with good management and low expenses may be a better bet for bonds than an ETF, in his estimation.
The ETF trend is here to stay. Though still dwarfed by traditional mutual funds in total assets, ETFs have been gaining ground.
"There's still about $10 trillion in traditional mutual funds compared to about $1 trillion in ETFs worldwide," says Justice. "But over the past three years ETFs have been taking their fair share of the money that had been going into actively-managed mutual funds."
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