Exchange Traded Funds (ETFs) are considered to be one of the investment world’s great inventions. When first launched back in 1993, ETFs represented an improvement over their earlier index mutual fund cousins largely because they allowed investors to trade throughout the day rather than accept only end of day prices.
Unfortunately, Wall Street, ever on the lookout for the next money making opportunity, has turned a relatively good idea into a quagmire. Today, investors have over 2,000 ETF products to choose from (see chart below). And while the original entrants were designed to track broad market indices such as the S&P 500, more recent products track everything from hedge funds to leveraged commodity markets. There is even an ETF that tracks the shares of companies issuing ETFs. Selecting from among the vast array of ETFs and the more than 9,000 active mutual funds available today has become just as challenging as assembling a portfolio of individual stocks.
Many financial service firms are aggressively marketing their ETFs as a way to cash in on the shift toward passive investing. Passive investing strategies are generally designed to produce market level returns. Ironically, however, defining “the market” requires a fair number of active decisions. If you want to track the returns of large U.S. companies, for example, you might invest in an S&P 500 tracking ETF. While this is reasonable, holding only this position eliminates exposure to smaller and mid-sized firms. What about adding international exposure or the all-important decision regarding how to allocate investments across different asset classes such as stocks, bonds and cash? The returns of any ETF-based portfolio will always be driven by these and other underlying “active” decisions.
The terms “low-cost” and “passive” often associated with ETFs should also not be confused with low risk. The risk of any passive investment product (mutual fund or ETF) is determined by the volatility of the underlying index it is designed to track. A well run index fund tracking the Wilshire 5000 should exhibit the same risk and return characteristics as the broad U.S. equity market but one tracking the Hong Kong Stock Exchange is going to behave much differently.
In an effort to attract assets, many advisors are peddling model portfolios using a broad array (sometimes 20 or more) of ETFs. While adequate diversification is important for controlling risk, this typically can be achieved by holding only 5-10 positions. The risks of holding too many ETFs include unintended overlapping positions (consider that Apple is a top ten holding in five of the 10 largest ETFs), exposure to less liquid segments of the market and higher fees.
Investors can make navigating this increasingly complex world easier by keeping a few tenets in mind. First, Keep Things Simple. As noted above, an adequately diversified, low cost portfolio can be achieved with 6-7 broad based holdings. Add to this only if you are sure the position offers genuine diversification. Second, as is always the case in investing, only buy what you understand. If someone is suggesting that you purchase a Brazil Bear 3x ETF which will go up or down 3x the Brazilian market, walk away! Markets that are thinly traded present additional risk so avoid them as well. Finally, understand the active bets that you are taking in your portfolio. This includes how to spread your assets both across and within asset classes. Unfortunately, for most investors, the success of the ETF business has made passive investing anything but simple.