If you are an investor, there is a good chance you have heard about exchange-traded funds. ETFs have become the fastest growing financial tool used by investors. Despite their popularity, many investors don't really understand what they are and how they are to be used.
ETFs are defined as "securities that track an index, a commodity or a basket of assets like an index fund, but trade like a stock on an exchange, thus experiencing price changes throughout the day as they are bought and sold." In other words, an ETF is a security that tracks some kind of stock or bond index and allows the investor to track that specific index closely through buying this one particular product.
For example, if an investor wants exposure to the S&P 500 Index, he can either buy all 500 stocks, which would be very costly and time consuming, or he can purchase an ETF. The ETF will track the S&P Index nearly point for point. Due to their low costs and simplicity, many investors are very keen to buy ETFs.
The first ETF was launched on the Toronto Stock Exchange in 1990. Three years later, the first ETF was launched in the United States, and they have been gaining in popularity ever since. Over the past five years, there has been an explosion of new ETFs, with hundreds of new products hitting the market, leaving investors scratching their heads trying to figure out which ETF is a good fit for their portfolio.
As is usually the case, when Wall Street senses that something is popular, it will produce it in mass quantity to make a profit. For this reason, many kinds of esoteric ETFs have been launched on all types of bizarre indices. My favorite is an ETF that specializes in metabolic endocrines - whatever that is!
There are now "inverse ETFs," which are a way to make money when the market drops. Leveraged ETFs have become hugely popular, especially among day traders, as they enable investors to get up to three times the leverage on a particular index.
With the recent market meltdown, lack of interest has caused many of these more-innovative ETFs to close down. Nonetheless, there are still many hundreds of ETFs left in the market.
With this burgeoning industry coming up with all kinds of new and innovative products, ETFs appear to have moved away from their initial role of allowing investors linkage to a broad market index. Instead, they are leading investors into a false sense of security that they are indeed diversified, when in actual fact they are far from holding a well-diversified portfolio.
There are many advantages to purchasing ETFs. First and foremost is diversification. By definition, ETFs give the investor potential exposure to hundreds, if not thousands, of different stocks, providing a well-diversified global portfolio, while investing passively without having to watch and follow a myriad of securities.
Another benefit of ETF investing is liquidity. Because they trade like individual stocks, ETFs can be bought and sold throughout the trading day, thus allowing active traders to try and time the market and cash in on intraday market moves.
How can an investor capture the advantages of these products while trying to wade through all the minutiae out there? More and more financial advisers have begun offering "Core ETF" portfolios. The idea is that these portfolios are globally diversified using basic ETFs. However, they follow mathematical models that help the investor obtain a well-diversified portfolio, while limiting some of the volatility that comes with investing.
This creates the benefit of being linked to many stock indices, with the knowledge that the most appropriate ETFs are being used. In this case, the client does not need to worry about which ETF to use. Rather, he relies upon the analysis and expertise of advisers who specialize in this particular field.
Many investors find ETFs useful in building their portfolio. But be aware that when you look at their results, past performance does not guarantee future returns. It may be worthwhile asking your investment adviser if ETFs can be used to diversify your portfolio in a low-cost, efficient manner.
Aaron Katsman is a licensed financial adviser in the United States and Israel and helps people who open investment accounts in the US.