The first exchange-traded fund came into being in 1993 with the S&P Depository Receipts Trust Series 1, or “SPDR” — an ETF whose mission was to replicate the risk and returns of the S&P 500 Index.
Similar to mutual funds, ETFs allow investors to “pool” their money to invest in a variety of stocks, bonds, commodities and even currencies.
And although I am a rabid individual stock fan, I also have made room in my personal retirement portfolio for a variety of exchange-traded funds to strengthen my diversification. In fact, about 10 or so years ago, I pretty much eliminated mutual funds from my holdings because ETFs have several distinct advantages over funds:
- Lower fees, on average. According to ETFdb.com, the most actively traded ETFs average fees of 0.72% compared to an average of 1.4% for mutual funds. Even better, ETFs that are more passive — such as ETFs that track indices — can see much lower fees.
- Better liquidity, as investors can trade ETFs all day long — just like stocks — whereas mutual funds trade only at the close of the business day.
- Greater tax efficiency. Unlike funds, where an investor has unrealized gains from the turnover in the fund — gains that are subject to tax upon the sale of the individual stocks in the fund — investors generally pay taxes on an ETF when they sell the instrument itself, not when the individual stocks are sold within the ETF.
It’s no surprise that ETFs have grown like wildfire! Just this year, fund flows into ETFs have surpassed $100 billion, according to SeekingAlpha. And 300 more ETFs were added to the growing pile, now numbering some 1,400 in all.
That’s great news for investors, but also not-so-great news.
While ETFs have given investors the opportunity to diversify their portfolios with great investments around the world, they also have followed the route of many other ideas created by Wall Street — the avenue of excess.
The no-brainer index ETFs have given way to a legion of exchange-traded funds — some good, some not so good. They include exchange-traded funds that track just about any index you can find, ETFs that make mega-bets against the market, factor ETFs that might take a bite out of hedge fund growth, and ETFs that are not only market-cap-weighted but also weighted by revenues, earnings, dividends, equal weighting and fundamental factors — just to name a few!
Consequently, investors no longer can throw a dart and find a decent ETF with reasonable risk and a good return. Instead, they must tiptoe through a minefield laden with ETFs that are ready to explode and smash their perceived profits into smithereens!
That just begs the question, “How does an investor choose a good ETF?”
First, let me say that I think investors in exchange-traded funds should have more of a long-term view than folks who are looking to make a quick profit. ETFs really should not be looked at as trading vehicles because of their construction. Instead, put them in your retirement portfolio, check on them every month or so, then sit back and let them grow!
But to do that, you have to choose the right ETFs, and they should have the following characteristics:
- Low volatility
- Reasonable management fees
- Wide diversification
- Meets your investment objective, whether it be growth, income or a combination of both
- High volume, which helps provide liquidity
- Low turnover
- Quality sponsor
- Based on a credible index
Many websites follow ETFs and can give you this information, but my favorite is www.Morningstar.com. There, you can sift through hundreds of ETFs, find a rating (if they have been trading long enough) and even screen for ETFs that meet your personal investment strategy.
Take an hour or so to get familiar with the site. To kick off 2012, I’ll give you some examples of each of these criteria, discuss the different types and styles of ETFs, tell you about the best and worst ETFs of 2011, and provide you with a few exchange-traded funds that you can put on your wish list for 2012.
I wish you all a very healthy and prosperous new year!