Exchange-traded funds versus mutual funds is an ongoing debate that likely will never end. There are supporters and detractors in both camps, and as long as these products continue to exist, investors will pour trillions of dollars into both. Each has its advantages and disadvantages, but that's a discussion for another time. (For more, see: Mutual Fund vs. ETF: Which is Right For You?)
Before we get to the types of exchange-traded funds, let's take a brief look at their construction.
ETFs are bought and sold just like stocks. They are easy to own, which makes them enticing to professionals and amateurs alike. Why take on the risk associated with buying an individual stock when you can trade an entire market sector, index or country?
Easy as it might be to trade ETFs, it's important you know how they're constructed so you can understand the risks that are involved. In short, shares of borrowed stocks are held in a trust to mimic a particular index. Creation units are then formed representing bundles of those borrowed shares. The trust issues ETF shares, which represent a small portion of the creation units, and those shares are sold to the public.
The biggest risk with ETFs is liquidity. Because ETFs can be sold short, if a panic ensues and a particular fund is heavily shorted, the fund might not have enough cash to satisfy those orders. It's a hypothetical problem, but one that is certainly possible. This risk can be mitigated by selecting ETFs with a good deal of liquidity.
Now, let's look at six common types of ETFs.
1. Equity Funds
Most ETFs track equity indexes or sectors. Some index ETFs mimic an index in its entirety, and others use representative sampling, which deviates slightly by using futures, option and swap contracts, and the purchase of stocks sometimes not found in the index. If this sampling gets too aggressive, it can lead to tracking errors. Any ETF with a tracking error above 2% is considered actively managed. As ETFs become more and more specialized, this is something investors should watch for.
The proliferation of ETFs provides investors with an inexpensive way to achieve diversification in their portfolios. Whether you want to capture a particular portion of the world's stocks, a broad sector or a niche market, there's an ETF for that. Further, others invest in different sized companies, whether you are after a small-, mid- or large-cap fund. Not only are there funds available for almost any area you want to invest in, with more coming to market each week, but there are also those that use different styles such as value or growth investing.
With the abundance of choices out there, it's important that you first determine your portfolio's equity allocation and then, based on those decisions, select ETFs to meet your investment goals.
2. Fixed-Income Funds
Most financial professionals recommend that you invest a portion of your portfolio in fixed-income securities such as bonds and bond ETFs. This is because bonds tend to reduce a portfolio's volatility, while also providing an additional stream of income. The age-old question becomes one of percentages. What amount should go to equities, fixed income and cash? This is commonly referred to as asset allocation. As with equity funds, there are many bond funds available. Investors who are unsure of what type to invest in should consider total bond-market ETFs, which invest in the entire U.S. bond market.
3. Commodity Funds
Before investing in commodity ETFs, it's important to understand why you are interested in commodities in the first place. Historically, commodities have had little price correlation with equities. Experts suggest that strategic asset allocation accounts for 90% of a portfolio's return. However, it's not enough to have stocks, bonds, cash, commodities and real estate in your portfolio. You should also diversify within each of those asset classes. That's where ETFs come in. Investors can buy a commodity ETF that tracks the price changes of particular commodities like gold or oil, or in a commodity stock ETF that invests in the common shares of commodity producers. The former has little correlation with stocks, while the latter is highly correlated. If your portfolio already contains equities, a straight commodity ETF may make more sense.
4. Currency Funds
As the world's currencies become more volatile and the U.S. dollar's role as a reserve currency slowly fades, investors wanting to protect the value of their U.S.-denominated investments will seek options that provide a hedge against a depreciating dollar. One option is to invest in foreign stocks or foreign stock ETFs. However, this won't provide you with asset class diversification because foreign stocks are generally correlated with U.S. stocks. A better alternative is to invest in foreign currency ETFs. Whether it's a single currency or one with a broader focus, the intention here is to insulate your portfolio from a depreciating U.S. dollar. On the other hand, if the U.S. dollar is appreciating and you own foreign stocks, you can protect the value of those holdings by shorting the same currency ETF.
It's important to remember that currency investing should represent a small portion of your overall investment strategy and is meant to soften the blow of currency volatility.
5. Real Estate Funds
Income investors wanting a little sizzle with their steak might consider real estate investment trust (REIT) ETFs. Whether you choose a fund that invests in a specific type of real estate or one that is broader in nature, the biggest attraction of these funds is the fact they must pay out 90% of their taxable income to shareholders. This makes them extremely attractive in terms of yield, despite the increased volatility compared to bonds. These funds are an excellent source of income, especially when short-term interest rates and inflation are near historic lows. (For more, see: How to Analyze Real Estate Investment Trusts.)
6. Specialty Funds
As ETFs became more popular, a variety of funds emerged to meet every conceivable investment strategy, much like what happened with mutual funds. Two of the more interesting are inverse funds, which profit when a particular index does poorly, and leveraged funds, which can double or triple the returns of a particular index by using leverage, as the name implies. You can even buy ETFs that do both. If you choose to dabble in leveraged or inverse ETFs, it is important that you understand the risks. In general, they are extremely volatile and unreliable as long-term investments.
A Quick Note on ETFs vs. Mutual Funds
ETFs originally were developed to provide investors with a more tax-efficient and liquid product than mutual funds. While ETFs are passive by design, as they've become more widely accepted, investment managers have developed actively managed funds, albeit with higher management fees, which seek to outperform the indexes. When selecting any investment, whether it is a mutual fund or an ETF, a primary concern should be what you pay to own it. Considering most money managers underperform their benchmarks, it's recommended that you thoroughly consider the pros and cons of these funds before making an investment.
Every ETF and mutual fund has tracking errors. The returns of the two products when tracking the same index are generally within a few basis points of each other. For most people, it comes down to what makes sense in your particular situation. If you are a do-it-yourself investor, ETFs probably make more sense. If you contribute monthly to an automatic investment plan, mutual funds likely will be your preference. Either way, it's important to understand what you're buying.
The Bottom Line
Since the introduction of the S&P 500 Depository Receipts in 1993, commonly referred to as spiders (SPDR), exchange-traded funds have exploded in popularity. Today, their mass appeal seems unstoppable. While they aren't for every investor, they certainly can play an important part in diversifying your portfolio, one ETF at a time.