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Diversify Your Investment Portfolio with Exchange-traded Funds

Brad Thurber

July 9, 2013

When Wall Street wizards create new financial solutions, the results are often either so complex or so specialized that mainstream investors rarely benefit. Many financial innovations over the last decade (swaps, derivatives, et cetera) might drive big profits at large hedge funds but are not generally intended for the average investor. However, one of the more recently developed financial advances has significantly impacted the market and created a world of opportunity for all investors—regardless of the portfolio size.

I’m referring to the evolution and proliferation of the exchange-traded fund (ETF).

While Toronto, Canada, is generally credited with the introduction of the first ETF, most historians would point to the SPDRs (ETFs that track the S&P 500) in the early 1990s as the beginning of the ETF industry. If we fast-forward to 2013, there are more than 1,200 exchange-traded products totaling more than $1.5 trillion. And that first ETF, “SPY,” or the S&P 500 ETF, still trades today and is the largest ETF, with over $125 billion in assets.

ETFs still pale in comparison to the U.S. mutual fund industry, at almost $20 trillion, but their popularity is growing quickly.

Flexible and Diverse

There are two identifiable factors that have led to the growth in popularity of investing in ETFs. The first is the development of online trading platforms that give virtually anyone access to ETFs at minimal costs. Second, portfolio diversification is one of the main tenets in financial planning and investors are paying attention. This other factor has created ETFs not only across various investment styles or market cap categories but across geographies, currencies and so on. The variety of ETFs available to investors is a testament to this desire for diversification.

While ETFs are composed of a basket of investments (like a mutual fund or index), they trade on the exchange like traditional stocks, offering investors liquidity throughout the day. Investors can execute the same types of trades they can with stocks—selling short, using limit or stop-loss orders, buying on margin and even making option trades.

Because of their passive nature—most ETFs are simply based on an index—their management expenses tend to be lower than those of comparable mutual funds (however, to compare the total costs of owning each, investors need to take acquisition costs into account as well). ETFs are also structured for tax efficiency, in that capital gains and losses are not distributed equally to shareholders but realized by the individual investor when he or she decides to sell.

Opaque and Complex

While all of these characteristics are victories for investors, ETFs aren’t perfect. One of the major concerns about ETFs is the lack of transparency in some ETFs’ inner workings. Most ETFs are fairly straightforward, with fund managers buying the specific components that constitute the index the ETF is tracking.

However, there is a growing number of ETFs that track their index through derivatives and complicated counterparty swaps. Simply speaking, this means that investors may not actually own the underlying assets they think they own when buying an ETF, but rather a combination of investments designed to imitate the underlying assets. As ETFs expand their reach into more exotic areas of the market, the use of derivatives will likely continue to grow.

ETFs are also attractive investments for high-frequency trading and other automated trading systems already under the microscope of regulators.

Finally, because if a little is good, a lot always seems to be better on Wall Street, companies are beginning to introduce leveraged ETFs, which are ETFs that try to achieve two or three times the returns of their non-leveraged counterparts. So, for example, if an investor was hoping to achieve two times the returns of the S&P 500, he or she could buy a leveraged ETF to accomplish that. The problem, of course, is that if the S&P 500 has a negative return, the investor will achieve two times that negative return.

Cautious and Disciplined

Because of the popularity of ETFs and investors’ appetite for investing in more exotic types of asset classes, the market has seen an explosion in ETF offerings. While ETFs used to be limited to some commodities, precious metals (gold being the most popular) and major indexes, investors can now find an ETF for almost any asset class imaginable. After covering the major investment classifications (geographic bucket, market cap, sector, investment style and asset class), ETFs have now branched into more far-reaching types of investments such as emerging-market bonds and clean energy companies. Any classification of investment an investor can imagine can likely be bought through an ETF.

So, because of their versatility, lower expenses and tax efficiency, ETFs can be great tools in an investor’s toolbox. Through ETFs, investors can easily access markets and investments that weren’t even imagined a decade ago, all at the touch of a button. However, with those opportunities, investors need to be cautious and disciplined in their approach; it is important to understand the inner workings of the ETFs they invest in and these ETFs’ potential shortcomings and risks.

Brad Thurber, CWS, CFP is a vice president and financial consultant at D.A. Davidson & Co.

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