The exchange traded fund (ETF) industry has grown considerably in the last 10 years. The currently available ETFs offer a wide range of investment opportunities. While not every fund may be right for you, does it justify criticism of the industry at large?
ETFs are used by more and more entities: institutional investors who use ETFs to invest new money quickly or hedge existing positions, financial advisors who use ETFs to create low-cost portfolios for clients, respected educational endowments and average investors who use them for long- or short-term trades, remarks John Waggoner for USA Today.
It’s no wonder, since ETFs offer a low-cost way to put money into stocks, bonds, commodities and real estate, and ETFs offer a way to bet on a segment of the market without having to deal with volatility in individual stocks.
The industry is not without its critics, though. ETF investors should be wary of the looming pitfalls associated with the investment vehicle. “Sometimes the temptation to trade overcomes investors’ common sense,” remarks Jim Lowell, founding editor of the ETF Trader.
Wall Street has been dangling ETF offers that may not be so good for the average investor, including, Waggoner says:
- Leveraged funds. Such funds offer twice or even three times the return compared to the underlying index. Note that the return is on a daily basis and they shouldn’t be used for long-term investing. The make-up of such funds also means that the losses are leveraged, too. [Leveraged and Inverse ETF Special Report.]
- Niche funds. There are more than 900 ETF options, and some funds are highly specialized. Potential investors are lured into specialized funds because of their huge gains. Investors should be aware that the specialized funds are volatile and, at times, thinly traded – low liquidity means share prices aren’t reflecting the benchmark index very well.
- Active management. The newest addition to the ETF world are actively managed ETFs. Professional money managers also eagerly use ETFS. According to Strategic Insight, institutional investors own half of the industry’s assets. Fund managers are looking to ETFs as a store for excess cash. Furthermore, financial advisors have warmed up to the idea of using ETFs in their investment portfolios. [More on Actively Managed ETFs.]
MarketRiders’ Tuchman also observes that fund providers may not have the investors’ best interests at heart in their rush to get new assets. Some new index funds try to reflect indexes that have been created just for the new fund. It is difficult to evaluate a fund without some data on how the underlying index performed over time.
I’ve known John Waggoner for more than 20 years. He’s a fair reporter and is trying to be balanced, but these criticisms don’t hold much water. Those who are critical of ETFs tend to not really understand their makeup and pricing. To be sure, ETFs aren’t perfect, but if the primary concerns are that there are too many and that they allow for speculation, a stronger argument is going to be needed.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.