Exchange-traded funds have become a very popular instrument among investors over the past decade.
The advantages of these products are numerous. The biggest issue seems to be that they can be freely traded throughout the day, unlike traditional mutual funds. What’s more, ETFs are not particularly limited in the investments they can own, which makes them the perfect vehicle to gain exposure to assets such as junk debt or emerging markets stocks — especially for the average investor.
ETFs can provide exposure to these themes and different markets at a fraction of the cost of traditional actively managed mutual funds or even hedge funds.
However, while ETFs have many advantages, not everyone is buying into the ETF story.
Jack Bogle, the founder of the world’s largest passive investment manager, Vanguard, has been a vocal critic of the structure in the past and other notable investors have also warned investors about the dangers of using ETFs in a portfolio.
So, the question is, are ETFs a good way to invest?
Should you be using ETFs?
I believe that at least one of the strengths of the ETF is also its greatest weakness. Liquidity is usually a good thing, but being able to trade ETFs throughout the day, encourages bad behavior among investors. It is all too easy to get out of a position with an ETF, which may not be the right decision if you’re acting on impulse.
Other passive investment vehicles, such as Vanguard’s tracker funds, have a dealing cut off time and cannot be traded throughout the day. This additional layer of friction is enough to make investors think twice before committing to exit a position.
The other widely cited issue with ETFs is the fact that with many of the more exotic assets these funds own, they’ve not really been tested in an extremely stressed market environment. We cannot be sure how ETFs (particularly in the distressed debt and emerging market space) will react if faced with another situation similar to 2008.
Having said all of the above, even though they do have their drawbacks, ETFs offer an invaluable service for investors when it comes to gaining exposure to specific market themes.
ETFs and themes
Using an ETF to gain exposure to, say, marijuana stocks is a great way to play the marijuana boom, but at the same time limit risk. Not every company in the space will be successful, and building a portfolio that is diversified enough to limit the risk from any one stock taking a dive would be a costly and time-consuming process without ETFs.
The drawbacks and advantages of ETFs point to the conclusion that these instruments may be best used as part of a broader portfolio.
Robo-advisors have been highly effective at combining ETFs to produce portfolios with targeted risk profiles with the notion that the diversification should limit and negative impacts — just as you would construct a traditional equity portfolio.
Using ETFs to invest in a particular investment theme or trend makes a lot of sense. As the cost of these products is usually below 100 basis points per annum, it is certainly cost effective for the average investor to buy an ETF rather than buy all of its components to make up a portfolio. This is the core of the issue. The ETF is a tool to be used to enhance performance and increase exposure. It does not seem to be a product that can replace the index fund or single stock selection.
Of course, these are just my views on the subject, and they are open to interpretation. The ETFs debate will likely continue to rage for some time, at least until we get an answer to the question of what happens to these instruments in a severe bear market.
For the time being at least, however, it looks as if they provide a fantastic tool for investors to complement existing investment strategies.
Disclosure: The author owns no stock mentioned.