Playing with spiders
CHICAGO — If you are wedded to the same mutual funds you have been using for years, you don’t have to think of yourself as an old fuddy-duddy.
It’s true that trendy investors are increasingly using exchange-traded funds, known as ETFs, as substitutes for mutual funds.
But to be in touch with the times, you need to know how and when to blend the new with the old, rather than running full-speed ahead into ETFs.
New ETFs are being churned out at a rapid pace and are giving entrepreneurial investment advisers a marketing hook to distinguish themselves from the competition and attract potential clients.
Yet, while ETFs can be a handy tool for individuals, many long-term investors wouldn’t miss much, if anything, by sticking with old-style index mutual funds. And traditional funds can be a better deal for young investors investing small amounts of cash.
In the last five years, the ETF market has grown to about $313 billion from $70 billion, and there are now about 200 different ETFs. The market remains small compared with the $8.8 trillion mutual fund business, but the annual growth of 29 percent is almost three times faster than that of mutual funds, and even zippier than hedge funds, according to the Financial Research Corp.
With names like Spiders, iShares, HOLDRs, Vipers, streetTRACKs and Powershares, ETFs tend to be a lot like typical index mutual funds, holding a broad collection of stocks for either the entire market, a chunk of the market or a sector.
They can be as simple as an index mutual fund that invests in the stocks that make up the Standard & Poor’s 500, or more unique like selecting the full range of the tiniest micro-cap stocks, or imaginative and very tightly focused. Think Powershares alternative energy ETF, which invests in companies like wind technology firms. Or the newest craze: ETFs that invest in commodities ranging from oil to gold through futures contracts.
The same warnings about these very focused investments apply whether an investor is using traditional mutual funds or ETFs. That is, diversified portfolios of stocks and bonds work best to keep risks at a minimum and increase money over time.
Focusing on a particular subsector like wind energy, or a particular part of the world like Brazil, might sound attractive based on the day’s news or your personal values, but being in the right place at the right time with very specific investments is hard to do and risky.
Financial planners tell investors to avoid sector bets. But if investors are adventurous, the rule of thumb is to use small amounts of money they can afford to lose, perhaps no more than 5 percent of an overall portfolio.
One attraction of ETFs is that investors can get in and out of them quickly.
With a traditional mutual fund, investors have to be patient. If, for example, they invest in a traditional small-cap mutual fund, and start noticing small-company stocks crashing in the market, they must wait until the end of the day to get out of the fund. By that time, they might lose a lot of money.
With an ETF such as the iShares S&P SmallCap 600, they could bolt immediately, because ETFs are bought and sold through a broker all day long, just like stocks.
Of course, timing the market right, even when you have an ETF, is hard to do, and most professionals suggest avoiding the temptation. They do, however, use ETFs to quickly fill holes in portfolios.
For example, if an individual had fled all large-cap growth funds after the technology bubble burst in 2000, he might have a significant absence in his portfolio now. Because strategists have been suggesting lately that large, fast-growing companies are relatively cheap and positioned to climb, investors might decide to refill that slot in a portfolio.
Instead of trying to decide which stocks might be the winners, an investor could toss a large-cap growth ETF into a portfolio on a moment’s notice, perhaps the Vanguard Growth Viper.
Professionals use this strategy often, picking ETFs for quick broad exposure to a type of investment they think is undervalued, ready to rally or one that’s missing when a client comes to them for the first time.
Whenever buying an ETF, investors need to check its contents. Some ETFs are heavily dependent on single stocks. For example, the iShares Dow Jones U.S. Energy ETF invests close to 21 percent of its portfolio in Exxon Mobil Corp. If you were holding the ETF, plus the company’s stock and another mutual fund containing Exxon, you’d have too much and would get hurt if it fell.
Professionals also use ETFs for more complex maneuvers, such as shorting, or betting that a certain sector of the market might decline in value rather than rise.