Your Investments: Making sense of ETFs

ETF is a security that tracks some kind of stock or bond index and allows the investor to track that specific index.

Economy (photo credit: Courtesy)
(photo credit: Courtesy)
If you are an investor, there is a good chance that you have heard about exchange traded funds. ETFs have become the fastest growing financial tool used by investors. The financial media is full of advice for individual investors on how to use ETFs to create well-diversified investment portfolios.
As part of their drive to get investors to do it yourself‚ they preach that you can have a great portfolio using lowcost ETFs. Despite all the attention they get and their surging popularity, many investors don’t really understand what they are and how they are to be used. Not only that, but there are thousands of ETFs out there, and how is an investor to know which ones to choose? What are they?
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 stock 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.
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.
Up until now, all is well and good. The question is which ETF to buy? There are multiple choices for investors on the same asset class. Take for example smallcap stocks that trade in the US. There are dozens of products for this asset class, and while it seems that they all may do the same thing, there are huge differences between them. Some can be tracking different indices and employing different strategies to track them.
Traditionally the index of choice for small-cap stocks is the Russell 2000. They define inclusion into the index by ranking in order of market capitalization from 1,001 to 3,000 in Russell’s total United States equity universe consisting of up to 4,000 companies. They also take into account market value of the company and level of the stock price.
There are other small-cap indices, such as the S&P small-cap 600. For a company to gain admission into this index they have to show positive earnings growth for four successive quarters. What this means is that you get an index with growing companies that are making money.
What makes the difference in indexing even more important is when you look at returns. According to data provided by WisdomTree, over the last 15 years the S&P small-cap index has outperformed the Russell 2000 by 1.8 percent per year, with less risk. For investors it doesn’t get better that that – higher returns and lower risk.
Most do-it-yourself investors would never know such statistics, and they can end up leaving lots of money on the table as a result.
Managed portfolio
How can an investor capture the advantages of these products (low cost and well diversified) while trying to wade through the thousands of products available? 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.
Be aware, however, 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.