Exchange Traded Funds

The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.

Over the past decade, exchange traded funds (ETFs) have exploded in popularity. Originally designed to track a broad market index at a relatively low cost, ETFs now come in all shapes, sizes, and levels of specificity. Most every segment of the market now has an ETF to track it. In this column, we'll take a closer look at exchange traded funds and discuss ways these tools can be useful in building a diversified portfolio.

Client: What's an exchange traded fund? Who were they created for?

Advisor: Exchange traded funds, or ETFs, are securities tracking a specified index or basket of assets in a fashion similar to an index fund. However, unlike an index fund, an ETF trades like a stock on a major exchange and the price fluctuates throughout the day. ETFs were originally designed to provide investors with a relatively low-cost method of investing in a particular index or segment of the market. ETFs provide instant diversification and allow investors to sell the index short, buy on margin, and purchase a smaller number of shares. (Most index funds have a minimum buy-in.)

Over the past several years, ETFs have gained in popularity with investors who believe there is no value to trying to outperform a market index or benchmark. ETFs allow investors to essentially perform like the market at a lower cost relative to most other actively managed mutual funds.

Client: That approach sounds pretty appealing. What are the drawbacks?

Advisor: On the surface, it seems an appealing alternative to other investing techniques. If you can spend minimal time achieving market-like returns, what's not to like? But, like almost everything market-related, it's not that easy.

Many "indexers" purchase ETFs planning to just let them "do what they do" over the next twenty years. Unfortunately, though this is a noble goal, you see very few able to stick to it. Why? Part of the reason most investors underperform the market is their (very natural and understandable) propensity to allow emotions to overwhelm objectivity. Many investors become spooked by even small short-term losses in their portfolio. It can be difficult to recognize short-term losses are likely temporary in the bigger picture. When market indices and the funds tracking them have double-digit declines, many investors panic and fail to stay the course. That panic can lead investors to sell out at the wrong time—making it likely they miss the opportunity for the positive returns they seek.

Really, buying a fund for the long-term and actually sticking with it are two totally separate things.

Client: Is there a better way to use ETFs?

Advisor: In my opinion, yes. There are certain instances when utilizing ETFs to gain exposure to narrow sectors of the market makes sense, from a transaction cost and diversification standpoint. For example, if I want an approximately 3% portfolio weight in Japanese stocks, I can more cost-effectively gain exposure and diversification with an ETF.

But if I purchased individual positions instead, I would have a few challenges. First, I would have to purchase multiple individual stocks, maybe 10 or more, to properly diversify in that narrow category. However, allocating only 3% of my portfolio to 10 or more positions can lead to big transaction costs. Since most brokerages charge minimum commissions for trades, buying 5 or 10 shares of a stock becomes much more expensive relatively than buying 100 or more shares. Second, even with 10 or so positions, I still wouldn't have achieved the diversification available with a single ETF that might track several hundred positions.

Client: So, why create a portfolio using anything but ETFs?

Advisor: First, even though it is not nearly as important as proper asset and sub-asset allocation, stock picking can still add value to your portfolio's return. Studies have shown nearly 10% of a portfolio's return is attributable to stock selection. If you have the time and ability to pick good stocks, you can likely add return.

Second, if you build an ETF-only portfolio, you still have many decisions to make. Do you use only broad index ETFs? Or do you use sector, country or size-specific ETFs? How much do you put in each one? When do you rebalance? How do you ensure the underlying positions in each fund don't overlap? Essentially, using ETFs this way requires active management—something an ETF user may be trying to avoid. Part of the ETF allure is their passive attributes and there's nothing passive about this type of approach.