ETFs: New Wave or Riptide?

There was an excellent article discussing the pros and cons of investing in Exchange Traded Funds (ETFs) in the July 3rd Wall Street Journal: As ETFs Seek Niches, Risks Rise (unfortunately, The Wall Street Journal doesn't allow us to link to their articles, perhaps that will change after Rupert Murdoch buys Dow Jones.) There's over $500 billion invested in Exchange Traded Funds and, I believe, they will either replace open-end index mutual funds or force those funds to lower their expenses. A win for investors. Exchange Traded Funds generally have lower on-going expenses then index mutual funds. You're charged a commission to buy or sell them, as for a stock, but the commission may be less then the fee charged by your broker, or fund, for buying a mutual fund (consider the share class you're buying). They are priced, and traded hourly, not at the end of the day as with open-end mutual funds.

ETFs are excellent tracking vehicles for many different kinds of investments. Want to invest overseas? In commodities? Buy an Exchange Traded Fund. (Not to get carried away, there are index funds that track most of the indices that do ETFs.)

So what's not to like about Exchange Traded Funds? Going back to The Wall Street Journal article, Lipper, which tracks fund performance, reported that a disproportionate number of ETFs showed up on its losers (poor performing) list. For some it is simply a case of tracking a narrow and volatile index, nanotechnology, for example. The lesson here is that investors need to consider the riskiness of any investment they're making. An Exchange Traded Fund doesn't diminish the risk of a cutting-edge technology, volatile commodity, or stock market of an emerging country. What a good one will do is reflect the performance of whatever index its is designed to track.

Like most new products, and Exchange Traded Funds are a new product, there will be some product-specific risks as well. Some won't track their underlying index due to design error or too narrow a portfolio. Costs won't automatically be less, turnover and taxes will be issues for some and to mitigate these risks stick with Exchange Traded Funds issued by well-known institutions.

Vanguard, the godfather of index funds, has joined the ETF party and is coming out with more. (See When is a Door Not a Door for more information on and what John Bogle, the founder of Vanguard, thinks of them.) Vanguard's action is perhaps the best evidence to date of the rise of ETFs.

The moral to the story is to consider Exchange Traded Funds whenever you're considering an index fund or want a low cost and liquid way to obtain exposure to a particular type of investment. Just remember that this doesn't reduce the risk of the investment class.

Bill Byrnes is co-founder of MUTUALdecision, a website providing mutual fund data, and the author of the MUTUALdecision Blog. He's been an investment banker with Alex. Brown & Sons and a Finance Professor at Georgetown University. He's been CEO, chairman and served on the board of directors of several public and private companies. He holds MBA and JD degrees and is a Chartered Financial Analyst with over 30 years experience in the investment industry.