Some rather sage thoughts from Value Line on investing in ETFs...
valueline.com
The Value Line Mutual Fund Survey
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Published May 16, 2006
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ETFs: The Good, The Bad
Exchange traded funds (ETFs) are all the rage. You can't read a finance magazine without hearing about these products and how they are just perfect for all of your portfolio needs. While there is a grain of truth in that statement, there is also the seed of a disaster waiting to happen.
ETFs are ingenious products that have some great advantages over mutual funds, both the open-end and closed-end varieties. Basically, the benefits boil down to this: You can trade an ETF like a stock at its net asset value all day long without paying huge asset management fees. Moreover, you can short ETFs and there are even options based on some of them.
There are, however, some broad negatives with regard to ETFs. For example, generally speaking, you must pay a commission when you buy and sell ETFs. This makes accumulating money over time very expensive, despite the low cost of ownership. Mutual funds are a much better option in this regard. Second, to allow for all-day trading, ETFs must meet strict disclosure requirements. As such, the current ETFs are all index-based and not actively managed. Where you stand on this issue is really a matter of taste, but the end result is that there is a limitation as to what can be done within an ETF's portfolio as compared with an actively managed fund.
The indexing issue is my biggest concern as it relates to average investors. The first batch of exchange traded funds was designed to track long-standing indexes, such as the S&P 500 Index and the Dow Jones Industrials Average. That made complete sense, as these indexes were widely followed and their constituents were well known. For someone looking to track a broad index, or a sub index, these ETFs were and are still viable options. The second wave of ETFs, however, has often been derived from obscure indexes or, worse, an index created for the sole purpose of later creating an ETF.
ETFs have attracted a huge amount of money over the last few years. For institutions and those will large sums of money to invest, these products can be a cheap and useful tool. In fact, there is an ETF that would be appropriate for most of the asset classes in Value Line's Model Portfolios (see table). I've also reviewed some modern ETFs that have been created based on sound principles, such as the Dividend-Achievers based ETFs. There is definitely value in some of these products.
Still, I have concerns about the popularity as the hot new investment idea because hot investment ideas generally lead to excesses and abuses. For example, there is an ETF in the works that is going to track initial public offerings (IPOs). It should be pretty interesting to see how that fund does, as it is often hard to get access to IPOs and harder still to get access to good companies going public. The risks here far outweigh the potential rewards, as far as I'm concerned.
The point I'm trying to make is that you need to consider ETFs very carefully. Just because they are the investment idea of the day, doesn't mean they are appropriate for you or that they fit well into your portfolio. If you are looking into buying an ETF, make sure that you understand what it does and why. Moreover, make sure that the investment concept makes sense to you. And try to avoid gimmicks, such as the IPO ETF.
Once an ETF passes this "sniff " test, the next question is whether or not it fits into your overall portfolio. Indeed, it would be a bad call to force an ETF into your allocation design if it doesn't fall naturally into place (using an IPO ETF to fill the small cap component of your asset allocation model, for example).
Overall, I am favorably disposed to ETFs. However, they can hold pitfalls if you don't understand what they are and why you own them. I brought this topic up now because we are preparing our special edition dedicated to exchange traded funds (it comes out after issue 8). As I've looked over the landscape in preparation, I definitely think there are signs of froth in the ETF market. So don't just jump into this fad—think it through.
Reuben Gregg Brewer
Editor
EK!!! |
