Exchange Traded Funds Make Sense for Investors, but as I Always Say…The Devil is in the Details!

Exchange Traded Funds (ETF’s) are a staple of our managed portfolios and all of our clients know that. Recently I read an article in the Wall Street Journal that highlighted some of the advantages as well as some of the pitfalls of investing in ETF’s. I hope you find it useful.

 

I’ve mentioned in previous weekly market commentaries that while the market has been climbing a wall of worry, money has been flowing out of equity based mutual funds. That money has been making its way into bond funds, hybrid funds, and money market funds. But equity based ETF’s have also seen a positive inflow of cash and with good reason.

 

ETF’s have a number of advantages over the more familiar mutual funds; everyone is well aware of that by now. But the article in the Wall Street Journal highlighted a few things investors need to keep a close eye out for. Here are a few they mentioned:

• Fees. While ETF’s can be much cheaper than mutual funds, some can be expensive. You have to know if the additional operating expense of the ETF is bringing value to you. Commodity based or emerging market ETFs tend to cost more to manage, but you need to make sure there is a reason for investing in any particular sector at any given time. For example, many commodities have been experiencing lower prices while many international markets have turned positive on their charts.   Some firms are adding additional fees to investors such as custodial fees. Since ETF’s have a low cost structure, and most investors consider themselves long-term investors, some firms are seeing their revenue decrease. Be sure you know all the fees you are paying for.
• High trading activity. Some advisers jump in and out of various ETF’s creating too much short-term gains and losses. The tax efficiency of ETF’s in non-qualified accounts is a tremendous benefit for investors. Any repositioning of a portfolio should always be based on changes in relative strength or on chart patterns. I tell people anytime we buy and anytime we sell and there is a technically sound reason for doing it.
• Chasing the latest thing coming down the road. As more and more ETF’s are being brought to the market, there is a concern that thinly traded or ETF’S based on obscure sectors may not last. Also, with little trading and low volume, wider price swings can knock investors for a loop. We’ve seen many ETF’s close over the last couple of years. You have to “check under the hood” to make sure you understand how the ETF intends to work.
• Compounding price movement. Along the same line, some ETF’s compound the upward or downward price movement of a particular sector or index. This type of ETF is best left for institutions which have professional traders watching price movements all day long. Finra and the SEC have both issued warning letters to advisers and brokers warning them of the complexity of this type of ETF.

In my opinion, ETF’s are one of the best ideas to come out of Wall Street. But not all ETF’s are created equal.