Exchange-traded funds: What are you risking? |

Exchange-traded funds: What are you risking?

Richard Loth

How many exchange-traded fund choices are too many?That question was asked by New York Times reporter J. Alex Tarquinio, in an article he wrote back in August. At that time, he noted the fascination ofthe average investor with the continuous roll out of new, and often exotic, exchange-traded funds, commonly known as ETFs. The investment industry has obliged the consumer accordingly and is cranking out an ever increasing number of ETFs with a wide variety of investment objectives.Tarquinio observed the following: “There has been no shortage of new ETFs in recent months, focused on niche industries, commodities or foreign currencies. The executives in charge of designing these new instruments say they have based their decisions on feedback from institutional investors and financial advisers who can use them in sophisticated strategies. But there’s nothing to prevent an individual investor without a financial adviser from, say, day-trading the Mexican peso.”Since then, the ETF bandwagon has continued to roll. In its November issue, Money magazine reports that there are now more than 270 exchange-traded funds with total assets exceeding $350 billion. That’s still a relatively small amount compared to the $9 trillion plus reportedly invested in mutual funds. However, ETF assets have grown fourfold in the past five years.That’s a lot of action. Tarquinio asks, “Is it wise, though, for individual investors to be doing so? Should do-it-yourselfers be trying to make the fine distinctions made possible by the new ETFs – between owning silver versus gold, or investing in oil producers versus oil equipment makers, or predicting the rise and fall of currencies or foreign stock markets?”Before answering these questions, let’s remember that ETFs are mutual funds or trusts that are listed on a stock exchange and trade like stock. They hold an underlying “basket” of stocks, or other types of securities, that track different parts of the market. You may recall that the original idea of the exchange-traded fund was simply to allow professionals to be able to trade mutual funds like stocks.There’s nothing inherently wrong with that. However, individual mutual fund investors have little need to participate in day-trading, selling short, trading on margin, placing limit orders on their buying and selling, or investing in very narrow, sophisticated segments of the market. That’s what most of the new ETF offerings are all about.Therefore, my answers to the questions posed by Tarquinio are, in the first instance, yes, 270 ETF choices are probably 264 more than are needed (more on this later) and, in the second instance, probably not. Hersh Sherfin, professor of behavioral finance at Santa Clara University in California,warns that the non-professional investor is “… vulnerable to being overconfident, so this very large array of choice really provides people with enough rope to hang themselves.” He adds that “… to the extent that new ETFs are being produced to capitalize on short-term momentum, the likelihood is that individual investors will up suffering.”My suggestion to individual investors is to look to exchange-traded funds as a way to obtain a highly diversified investment in stocks through six (youcan forget about the other 264 ETFs) broad-based market ETF offerings.You can have all publicly traded U.S. stocks (+/- 6,000) in the Vanguard Total Stock Market VIPERs (VTI). The popular, first ever ETF, SPDR Trust Series I (SPY), puts you into the large-cap stocks of the Standard & Poors 500 Index. The Vanguard Mid-Cap VIPERs (VO) tracks the medium-sized companies in the MSCI U.S. Mid Cap 450 Index. The iShares Russell 2000 Index Fund (IWM) covers the market for small stocks. International and real estate diversification is provided by iShares MSCI-EAFE (EFA) and iShares Cohen & Steers Realty Majors Index Fund (ICF), respectively.I would be very careful about investing in ETFs with narrow, specialized investment objectives.Richard Loth is an independent registered investment adviser who runs Mentor Investing, and is a writer/publisher of investment education materials. His latest book, “Finding Investment Quality in a Mutual Fund,” is now available. E-mail inquiries to or call 328-5591.Vail, Colorado

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