ETF Speed Dating: Chemistry to Compatibility to Commitment

Do exchange-traded funds make a good match for your portfolio? Start with a basic compatibility test.

Long before you ever take them home to meet mother, spend a little time getting to know exchange-traded funds (ETFs). Sure, they’ve attracted mainstream investor attention for nearly two decades now, so you may already know a thing or two (or think you do). News, promotions, and analyst coverage of these actively tradable, index-like products probably flood your inboxes as new ETFs roll out all the time.

Whether you’re just starting out, or in need of a little refresher, let us give you a quick introduction, or reintroduce you, to ETFs:

ETFs are baskets of securities that typically track a sector-specific, country-specific, or a narrow- or broad-market index and are thus considered to be passively managed (someone isn’t actively choosing which stocks to buy and sell). They list on an exchange like a stock so you can conveniently trade them through your brokerage account. They can appeal to active traders and hands-off investors alike. ETFs’ role (offering diversification, hedging, potential income, and a potential tax benefit with fewer capital gains) can evolve with your investment goals and risk profile. That relationship can even change with the ups and downs of the market.

Good Chemistry?

• COMFORT LEVEL  The risks of index ETFs are typically limited to the same percentage risks as the indexes they track. The risks of sector-based ETFs depend on the basket of stocks they track, including the weighting of each stock. Because you can choose broad-based indexes or narrower industry choices, index and sector ETFs can be a starting point.

• TRADERS TOO  Contrary to some thinking, ETFs can be a good fit for active market participants too; they can be shorted, hedged (with an offsetting position), bundled (buying several at one time as a potential cost-saver) and many have options traded on them. They sometimes bring less volatility than individual stocks, yet potentially more flexibility than mutual funds. Active traders might consider ETFs as a diversifier to deal with potential “surprises” that can accompany trading individual issues of stock.

• IT’S COMPLICATED (SOMETIMES)  ETFs have gotten more specialized over the years. Experienced investors might consider “hybrid” ETFs that are leveraged, inverse, sometimes both. Special risks are associated with these funds. Before trading these very distinctive products, be sure to learn the risks, and keep in mind that most of these are intended for very short holding times, often as short as one day.

• TAKING IT SLOW  ETFs aren’t for everyone and certainly, not every situation. For instance, no-load mutual index funds might be a better fit than ETFs if you prefer dollar-cost averaging. That’s where you build up a portfolio slowly and in pre-set increments. ETF trading costs could pile up, eating up your potential profit, if using such a strategy. For instance, the transaction costs associated with buying one share at a time can be prohibitively high.

Background Check

• SKIN DEEP  ETF  Popularity has forced the marketing folks to get creative with naming this product and catchy acronyms and action words keep ETF proper names easy on the tongue. But be sure to look at what’s behind a name by scrutinizing an ETF’s holdings and objectives as you would those of any mutual fund. Make sure the ETF label matches the underlying securities.

• CHEAP DATE?  By construction, ETF investors have less exposure to capital gains taxes than actively managed mutual fund shareholders. That’s because mutual fund managers frequently buy and sell the fund’s holdings, ideally at a profit, and pass along those tax obligations to shareholders. ETFs occasionally move shares around, too, although much less than most managed mutual funds. Annual expenses for ETFs range between 0.1% and 0.65%, according to fund-tracker Morningstar, Inc. Index mutual funds tend to charge anywhere from 0.1% to an average 1.5% (the high end reflects actively managed), according to the Investment Company Institute.

Play The Field

• SHORT PLAY  Select ETFs can help investors hedge a portfolio of stocks against potential volatility in the market. For instance, you might consider selling a comparable index ETF against your portfolio so that if the market does drop, the loss on your portfolio may be reduced with gains in the short ETF. Keep in mind, though, that the risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security.

• BEWARE…BETA  They may track the same stocks and offer easy diversification, but subtle differences between index mutual funds and ETFs can affect long-term returns. ETFs (stocks, too) have beta, a measure of the volatility of a security or portfolio compared to a market or index. This means that ETFs can move up and down with the broader market. For instance, if your portfolio is centered largely on small- and mid-cap stocks, investing in the broad-based ETF QQQ, which tracks the Nasdaq- 100 Index, would add more of the same type of risk to your portfolio. That’s adding beta. A beta-beater, then, might include adding the Nasdaq 100-tracking QQQ when the bulk of the rest of your portfolio is closely aligned to the broader S&P 500.

• YOU HAVE OPTIONS  Options on index ETFs are often used by traders as a first entry in to the world of options. That’s because many ETFs have single points between strikes. Single-point strikes help new investors define the maximum risk even before executing the trade. ETFs can keep investors focused on defining maximum risk, plus they can be relatively less volatile than individual stocks. For example, if the value of the difference of adjacent strikes is $100, you might create option spreads with a maximum potential loss of $100 or less. Options are not available on all ETFs.

Committed Relationship

For some investors, ETFs may be best used as a long-term investment tool that’s not so actively traded. This can work too. The same reasons that you fell for them in the first place apply; they can be diverse, accessible, and approachable. (Their potential flaws don’t go away either; watch beta, volatility). All told, the longer-term role of ETFs in your portfolio is rather straight-forward: filling out asset allocation gaps and replacing potentially higher-fee mutual funds.

So, what do you think? Another date?

Editor’s Note: This article was originally published in August 2012.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.