Exchange Traded Funds, like many new products that have hit the investment market in the last ten years or so, have made steady inroads among hardcore investors looking to use these often specifically indexed funds to "park" money as a hedge against other trades or as way to take advantage of a broader market bet. These are professional maneuvers that come with costs and are probably not good for the average investor.
First off, let me explain what an ETF is. Exchange Traded Funds are basically index funds. Index funds are basically passive in nature, mimicking a published list of the stocks grouped together, such as the top 500 companies (published by Standard and Poors) allowing the investor to purchase a fixed group. They can also be broken down further to include numerous other indexes from mid-cap, small-cap and indexes of stocks from around the world. These funds, like their mutual fund counterparts have sliced and diced the world into segments.
For instance, if you think India is the next big hot spot. There is an ETF that buys the broad market along with some smaller regions in that country. Do you believe that Latin America will recover first? There is an ETF that allows you to play that economy. Perhaps you feel as though a stake in a commodity such as oil or gold is the next best place to invest. There are ETFs for that as well. Even bonds are covered.
ETFs, because they fall outside the realm of mutual fund regulation, also offer some savvy investor the ability to short (borrowing shares in the hope that the price will fall and then, buying the less-expensive shares) or leverage (using some stocks as collateral for purchasing more shares) or buy real estate without the REIT.
And while that sounds like a world we should all play in, for most of us it simply won't work.
Because Exchange Traded Funds are traded throughout the day, investors using them can buy and sell a position without waiting for the 4pm close that mutual funds have. The downside: ETFs also create brokerage charges in and out of the position and because of that, do not give the impression that this is a park and hold investment. The double downside: this create volatility that rattles the market in the hour before the close.
There is also a transparency and a legacy issue. Despite the publicized passivity of the fund, there is not always a good indication of just what the index represents at any one given moment. They also have not been around long enough to compare to mutual funds. New ETFs pop up everyday as the world gets chopped up into increasingly smaller chunks. And this creates a problem as well. Index funds stick to the index they track or the index they claim to mimic. ETFs can have some style drift within the fund making them difficult to pinpoint with any real accuracy.
ETFs are index fund cheap as well. An upside for any investor looking to keep the overall expenses of investing at a minimum. They rarely mention the cost of trading these funds, just the convenience.
The question is: do they belong in your 401(k)? Sharebuilder thinks so and has announced their launch of a new program for advisers to sell. Designed to make the interaction small businesses have with these registered investment advisers (RIAs) easier and more seamless, low cost ETFs will make up 100% of what these plans offer.
According to ShareBuilder these "investment offering consists of a preset line-up of 16 ETFs from popular funds offerings like a S&P 500 ETF to important fixed asset categories like treasury inflation protected securities (TIPs) not common today in most plans. ShareBuilder 401k also provides five model portfolios to help make it easy for participants to get off on the right foot."
Once again, is this right for your retirement portfolio? While we have discussed how fees can eat up a great deal of the potential profits an investor might expect. And if they are hidden as they so often are (the fees I am referring to are more from the adviser end of things) as little as a one percent increase over what a small business is paying could impact returns over the course of a working career as much as 17%. Sharebuilder promises that this new plan will be less expensive to operate with features such as auto-enrollment and auto-rebalancing thrown in for good measure.
But by making the plan completely ETFs, the risk level drops considerably. The average employee will relinquish more control to index funds than is needed to raise your portfolio's earning potential. Small plans will have a limited number of the these index-type offerings narrowing the potential for better-than-average results. In fact, your results using only ETFs will be average.
ETFs can be used as a tool for investors. But to have them solely as a tool for those planning on retiring, seems to serve the adviser more than the client.