7/18/2011 10:58 AM ET|
ETFs for conservative investors
Exchange-traded funds can offer an affordable way to broaden your investment options beyond index mutual funds. But there are also drawbacks to consider.
Exchange-traded funds are making a big impact on the 80-year-old mutual fund industry, but do these newer products belong in conservative portfolios?
Some regulators and investors warn of hidden risks in ETFs, which, like stocks, are traded on a stock exchanges. While many of the concerns are valid, tarring the entire ETF industry is the equivalent of throwing the baby out with the bathwater. ETFs don't all have the same operational and investment risks.
In fact, many ETFs are perfectly suitable for the portfolios of investors who have adopted a cautious approach to achieving their investment goals. That's because simplicity, low costs and diversification are among ETFs' most compelling traits.
Below are quick tips for navigating the ETF thicket.
Harnessing the 'trade' in ETFs
Not every investor needs ETFs. While they may be tax-efficient and cheap, so are many index mutual funds. The virtues of ETFs may not justify the additional complexity. (You can save a few bucks changing your car's motor oil yourself, but I wouldn't recommend it to everyone.)
ETFs are at least somewhat hands-on. They are bought and sold like stocks, and they have similar liquidity considerations.
Trading a smaller and less-active ETF, say one with less than $100 million in assets, requires more caution than buying a mutual fund. You might end up buying at a premium or selling at a discount.
Fortunately, the cheapest, most-efficient ETFs tend to be liquid. Stick to big ETFs for an added measure of safety.
And always use limit orders to buy ETFs near net asset value. Even rare events like last year's flash crash, which briefly resulted in many ETFs trading at steep discounts, could have been avoided by judicious use of limit orders.
A key consideration for cautious investors is that ETFs incur trading costs. If you're paying $7 a trade and are trading only a few hundred dollars at a time, a mutual fund is probably preferable. ETFs are best when dealing with large amounts of money. Smaller investors should look to Vanguard, Charles Schwab (SCHW, news), Fidelity or TD Ameritrade (AMTD, news) for low-cost or free trading of selected ETFs.
It may be prudent to avoid ETFs if you know you have bad investing habits that could be exacerbated by the liquidity and variety of ETFs. Bad habits might include trading too frequently or attempting to play macroeconomic themes through wholesale shifts of your asset allocation, regardless of tax and cost considerations.
Avoiding behavioral mistakes can save you a lot more than the relatively minor savings you can gain with ETFs.
People trading their own portfolios also should consider the role of investments in estate planning. If you hold ETFs that need to be manually rebalanced, will your children remember to do this? Will you be able to monitor your statements should you have a medical emergency that takes you away from your computer for several weeks?
Among the appealing choices are the Vanguard Total Stock Market ETF (VTI) or iShares Barclays Aggregate Bond (AGG) fund. These and similar ETFs track broad, diversified indexes such as the MSCI U.S. Broad Market Index or the Barclays Aggregate Bond Index. These funds are simple, transparent, cheap and liquid.
While most ETFs are index funds, not all indexes are good. Some are essentially computer-run, active strategies or alternative weightings that may or may not make sense. As always, do your due diligence to determine whether an ETF fits with your investment goals and personality.
Outside your comfort zone?
The broad diversification of ETFs means that a complete portfolio can be built with just a few securities. If you have specific needs and are looking to venture off the beaten path, look at exotic funds, including leveraged or structured products. ETFs can expose you to investments that most of us had never heard of five years ago. Unless you are an active trader, there is no need to invest in a sector-specific fund like the Technology Select Sector SPDR (XLK). Similarly, conservative investors will have little use for expensive, complex, structured products like the iPath S&P 500 VIX Short-Term Futures (VXX) exchange-traded note.
In summary, conservative investors can benefit from certain ETFs, and there is no compelling reason to go outside your comfort zone.
But bear in mind that not all ETFs are user-friendly, and that all ETFs require at least some knowledge of basic trading strategies. Also, when planning your estate, it's best to simplify your portfolio to avoid setting up a future burden.
This article was reported by Michael Rawson for Morningstar.
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