By allowing ads to appear on this site, you support the local businesses who, in turn, support great journalism.
Exchange Traded Funds: What to know before making ETFs part of your portfolio
Many investors aren't familiar with exchange traded funds, a variant of mutual funds which can offer added diversity to many portfolios. - photo by Jeff Wuorio
Exchange traded funds have been around more than two decades, but they have remained largely unknown to many investors.

That changed about two months ago when the ETFs carefully designed function of mirroring the price movement of a group of other investments went off the rails.

Amid a 1,000-point drop-off in the Dow Jones Industrial Average on Aug. 24, several stocks in the S&P 500 which comprises some of the largest companies in the world stopped trading. But ETFs that tracked the S&P benchmark continued to trade, causing a significant difference in the value of the stocks themselves and the corresponding ETFs.

This decline represented a temporary mismatch between the actual benchmark and the underlying holdings, explained Michael Malvin of Decision Investments in San Diego. A seller in this brief window would receive as much as 19 percent less than the intrinsic value of the holdings a buyer was able to take advantage of an attractive situation for an 18 percent profit in about an hour.

The incident, which has regulators looking at ways to prevent a similar occurrence in the future, called attention to the funds that have otherwise proven to be a cost-effective strategy for some investors to buy into markets they otherwise couldn't access and diversify their portfolios.

ETFs are something that many individual investors and even experienced investment managers and advisers ignore, said Alexander Parker, chairman and chief executive officer of The Buxton Helmsley Group, a New York investment management firm. However, many times ETFs are a better option when compared to mutual funds because of the lower fees that they have on average when compared to mutual fund products.

ETFs defined

ETFs have been around for roughly 20 years and have close to $2 trillion in assets under management. Mutual funds and ETFs are similar in many ways in that both represent a grouping of different kinds of investments that are purchased and then sold for a single per share price. Like mutual funds, ETFs offer investors diversity across a broad range of investments. That offers growth potential while minimizing risk.

ETFs closely resemble index funds in that they track the performance of other groups of investments, such as the S&P 500 and other indices. But they differ from conventional mutual funds in that ETFs are traded actively throughout the day, meaning their price can change until the close of trading. By contrast, mutual fund values change only once daily.

Given ongoing trading, ETFs offer investors faster response time in terms of buying and selling.

ETFs inherently are much better in terms of liquidity for the average investor, being you don't have to wait until after the market closes for your mutual fund sell order to be processed by the fund administrator, said Parker. You can simply sell your ETF shares during regular market hours.

Another significant advantage is low expenses. While some ETFs actually carry no expense at all, others charge as little as 0.04 percent. By contrast, the average expense ratio mutual funds in 2014 was .70 percent, according to the Investment Company Fact Book.

Another plus is tax exposure. Given the particulars of how ETFs manage changes in their portfolio known as the creation/redemption process many ETFs dont distribute capital gains (the profit that derives when a stock or other investment is sold, which triggers a capital gains tax.)

ETFs that track stock market indices rarely, if ever, distribute capital gains, which are common in the case of actively managed mutual funds, said Kevin Prendergast of EFG Advisors in Schaumburg, Illinois.

Drawbacks to ETFs

ETFs aren't entirely free of fees. Since they are traded like stocks, theres a commission to be paid every time many ETFs are bought or sold. By contrast, no-load mutual funds have no attached commission structure.

As evidenced by the Aug. 24 incident, extreme market volatility can be another concern. Stock market and Securities and Exchange Commission officials are reviewing the incident with an eye to adding safeguards to prevent a similar occurrence in the future. One possibility is introducing a different system of curbs to make ETFs more responsive when corresponding investments stop trading.

A final caution pertains to the tradeoff between ETFs and investing in individual stocks. Although ETFs are generally low cost, even the most modest fee adds an expense that could be avoided by investing in stocks directly.

My personal opinion is that ETFs are widely overused due to the lack of investment advisers who are able to pick individual investments, said Parker. If you are looking to engage a buy-and-hold strategy by adding only undervalued stocks, it is unwise to utilize mutual funds or ETFs in your portfolio, being that you add that extra layer of fees.

Diverse portfolio

Although investor interest in ETFs has grown in recent years, not all ETFs function the same. For instance, some ETFs are better at tracking their corresponding index than others (known as tracking difference.) Even the means through which shares are sold using a system involving "authorized participants" will seem unusual to many newcomers.

The website Investopedia has a helpful primer.

All ETFs are not created equal and the differences can be important, said Malvin. Greater education about ETFs is important to help individual investors avoid getting into situations they don't fully understand.

One ETF strategy allows access to certain kinds of investments that, under different circumstances, might be unsuited to some individual investors. For instance, ETFs that track commodities, like precious metals, provide a cost-effective and safer means of investing in this market.

ETFs can be fantastic as most of them are designed to give you participation in a segment of a market that you are interested in with little concern of underperforming, said Malvin. Most of the time, ETFs can track an index or commodity value with expenses that can either rival or beat even the least expensive of no load, index mutual funds.

Investment professionals also see ETFs as a means to further the overall diversification of a portfolio, complementing mutual funds, stocks and other investment choices.

While ETFs come in many different flavors, they are used most efficiently as components of a diversified, long-term, strategic portfolio, said Prendergast. The portfolio should contain a mix of ETFs designed to track stock and bond market indices in a manner that reflects each investor's risk tolerance and investment objectives.