There are now over 1,600 exchange-traded products available to investors, and total assets are quickly approaching $2 trillion. Traditionally, the primary way an investor could get access to a diversified portfolio of stocks was through a mutual fund. But today, many of these investment products mirror the overall market, providing very little differentiation. Good managers are hard to come by. This, coupled with sometimes high expenses, has resulted in subpar performance for much of the mutual fund industry.
If an investor’s goal is to replicate the holdings of an index, another investment option is the often low-priced exchange-traded fund. However, there are complexities in this emerging investment class. With the continued interest in utilizing exchange-traded products for investors’ portfolios, it’s crucial to consider a number of things before you invest in an ETF.
1. Investment objective. Are you looking to invest in a broad market index, or are you more laser-focused on specific sectors or themes? If you’re looking for broad-market or index exposure, ETFs can be a low-cost, well-diversified option with potential tax-efficient components for an investment portfolio. For example, gaining exposure to the Standard & Poor’s 500 index through the SPDR S&P 500 ETF (symbol: SPY) or looking for access to the Dow Jones industrial average through the SPDR Dow Jones Industrial Average ETF (DIA) is straightforward. There’s not a lot of research needed, since those products track the performance of the corresponding index, minus expenses.
However, it is a much different story when you’re looking to gain sector or theme exposure because it’s crucial to know which stocks are owned within the ETF. If you’re looking to gain exposure to the energy sector, the Market Vectors Oil Services ETF (OIH) may pique your interest. However, if you look under the hood, you will find that you’d own only 26 companies. Additionally, OIH is very top-heavy with virtually 20 percent equity in Schlumberger and almost 12 percent in Halliburton. The question then becomes: Are you better off just owning those individual companies and removing the expense of an ETF? Conversely, you may not be accomplishing your goal of diversification if you’re invested in a concentrated ETF. In those cases, you may consider a broader ETF. Exchange-traded funds concentrating in specific industries are subject to higher risks and volatility than those that invest more broadly.
2. Tax features. Another factor to consider is taxation of the ETF. Most products have a structure that is taxed at capital gains rates. However, there are some that hold derivatives, which could require a Schedule K-1 tax form. If you’re looking for exposure to commodities (particularly precious metals), you may be subject to the collectible tax rate. You should consult with your tax advisor before making an investment in an ETF or you could create some unintended headaches.
3. Fee structure. You should also do some research in regards to the fees associated with owning an ETF. One of the benefits of investing in ETFs is their low-cost nature. However, many people do not know that the published expense ratio only covers management, administration, custody and auditing fees. There are additional costs that aren’t included in the expense ratio, such as brokerage fees, rebalancing costs and trading spreads. You should understand this total cost of investing prior to making an investment decision.
4. Product structure. Knowing the difference between an exchange-traded fund, which actually owns the underlying securities, versus other exchange-traded products, which may have different structures, is an important consideration. There are often key differentiators to be aware of before investing.
5. Performance. Lastly, you want to have an understanding regarding the expected performance of the exchange-traded fund. In most cases, the goal of investing in an ETF is to closely track the performance of an index or sector. With the proliferation of ETFs, there are a number of them that come up short in this regard. This may lead to large tracking errors or discrepancies between the benchmark and the underlying fund, which defeats one of the primary purposes of these investment products.
While ETFs are quickly becoming a popular investment in the marketplace, consider these five factors before investing in an ETF. Be sure to consult with your investment advisor before making any changes to your portfolio.