Friday, June 24, 2011

The Lure of ETFs

I know two things about exchange traded funds (ETFs). There is a high degree of likelihood that your 401(k) will soon have these investments available to you and that some of the basic selling points of why they might be a good choice will be too tempting to pass up. But you should consider the consequences of biting that ETF apple, not just from the consideration of whether the investment is worth the effort, but also from whether you are the investor you think you might be.

So let's first ask whether you understand what ETFs are. At first glance, they seem to be a good choice. They, at least on the surface offer exactly what index funds do and at times, a great deal more. They claim to be less expensive and more tax efficient that actively managed mutual funds and they are. Actively managed mutual funds, even as they have reduced their overall fees in order to placate those who worry that cost is an issue, still charge more than ETFs.

Actively managed mutual funds still dominate the 401(k) world and with good reason. Investors seem to understand, even after several years of concerted efforts by the investment community, that some risk is worth paying for. This is not always the case. The deduction of those fees against any returns you may have had illustrate why these funds are often criticized. Comparing them to an index fund, while often not necessarily fair, further shows that had you paid less in fees using an passively managed index fund you probably would have been a little bit closer to what you think of as profitable.

Passively managed funds such as index funds have passionate advocates. They believe that investing in the low-cost (because they rarely trade and do so only rebalance when the index changes) and in the case of the S&P 500 index, reinvest dividends (over 350 companies in the 500 index do) you have achieved the tax advantage, the fee advantage and because of that, a more profitable retirement dollar.

Both of the descriptions of the two most commonly used types of funds in a retirement account portray the investment possibilities facing most investors. It should be noted that not all 401(k) plans have index funds available to their participants, the option is growing. But also entering the fray is the exchange traded fund.

Now these investments will be tempting. They tout their tax efficiency suggesting that it is even better than an index fund offers. They advertise their transparency and ease of trading (they trade on an exchange just like a stock). And they never fail to tell you that these investment offer the world in a way that has never before been offered to 401(k) investors, a chance to invest in commodities, emerging markets and anything in-between. And because of this ease of maneuvering in and out on a whim, they claim to lower risk as well.

But do they do what they claim they will do? This is debatable. First, they are not index funds. They do not necessarily purchase all of the stocks in an index even as they suggest they might. Instead, many ETFs create their own indexes to follow and seek to invest in places where indexes have yet to trod. Mark P. Cussen, a financial planner for the military wrote recently about a little understood method employed by ETFs to get gains that seem better than the index they are suggesting they mimic. He wrote: "Most of these funds are usually leveraged by a factor of up to three, which can amplify the gains posted by the underlying vehicles and provide huge, quick profits for investors. Of course, leverage works both ways, and those who bet wrong can sustain big losses in a hurry." Leverage is another word for borrowing.

If there is an asset class, there is an ETF looking to exploit it. if you are hearing a lot about a certain class, such as precious metals, the temptation to join in the fray might be too hard to avoid. ETFs allow you to jump in "with the herd" and sell "with the herd". neither are necessarily a good idea and if you keep in mind, the low cost and tax efficiency of doing so are mostly wiped away. In order for ETFs to be both of those, you need to buy in large lots, offsetting the cost of the trade (commission) and you need to hold them for over a year. Small traders, which is the vast majority of us do neither - and won't if you buy them.

I mention "the herd". This mentality os what will drive you to consider this investment once it makes its debut in your plan. Instead, consider the vanilla index fund and what has become known as the tactical strategy. This employs a portion of your plan to just such whims while keeping the larger portion in the funds that will do the best with the least cost.

A tactical strategy might look something like this for young to middle aged investors: seventy percent of your assets in three to six index funds and thirty percent allocated to ETFs or even actively managed funds. Older investors might do the same but keep in mind that many major economic watchdog groups have warned that ETFs could be the next global financial troublemaker. And if that happens and happens quickly, the losses on that side of your portfolio close to retirement might find you less likely to retire when you want.

You will be tempted. And many of you will bite. But don't think that this investment can't bite back. It can and it might and unless you plan for such an occurance, the teethmarks it leaves in your plan might be long-term and scarring.

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