ETFs have exploded in popularity over the past few years. And for good reason, they are attractive securities with many appealing features and potential uses. But, like other engineered financial products, they can also be misused. In fact, the greatest danger with ETFs is that they could reinforce the investor behavior that is most detrimental to long-term investment success.

What Are ETFs?
An Exchange Traded Fund is a un-managed basket of securities (like an index mutual fund) designed to follow a particular sector of the market. Unlike an index fund, however, you can buy or sell an ETF at any point during the trading day just like a stock, rather than only at the net asset value (NAV) at the end of the day, as with a mutual fund.

Many ETFs are designed to track an existing index such as the S&P 500 or the Russell 2000, while others are created by their sponsors to mimic a particular sector. There are hundreds of ETFs covering such areas as biotech stocks, growth stocks, emerging markets, and even individual countries such as Malaysia.

ETFs Offer Several Important Benefits
We are obviously fans of pooled portfolios of securities given that we primarily use mutual funds, and like mutual funds, ETFs offer diversification, liquidity and professional (although passive rather than active) management.

As we have written in this space, we care quite a bit about costs, and so our typical mutual fund holding has a lower expense ratio than peers, as well as a lower turnover ratio and tax cost ratio. ETFs also have low expenses, low turnover, and are very tax efficient. ETFs can also avoid capital gains because they can pay off redeeming shareholders with baskets of their underlying portfolios' stocks instead of cash.

The additional liquidity offered by ETFs, in that you can get into and out of them at any time in the market day, can also have its advantages (though this attribute is a bit overrated for a couple of reasons that I will address later).

But perhaps the most important benefit of ETFs is that they offer exposure to many more niches of the market than are available through traditional index funds. When building truly diversified portfolios, having the ability to access so many style pure exposures clearly has value.

A Variety Of Investment Applications
There are a variety of ways that ETFs can be useful. An obvious use is in “tax swaps.” If an investor holds a security with a loss (in a taxable account), the investor could sell that position, then buy an ETF providing a similar market exposure, thus “harvesting” the loss for tax purposes. After the 30-day wash-sale period has expired, the investor can then swap back into the original security. In effect, the investor was able to realize the economic value of harvesting the tax loss without sacrificing their market exposure.

In a similar fashion, if a mutual fund is anticipating a significant capital gain or income distribution, a taxable investor may not want to put money to work in that fund until after the distribution. Again though, if the investor wants that market exposure, then an ETF (or other mutual fund) could be used in the interim.

As noted earlier, a key benefit of ETFs is their coverage of so many niche areas of the market. This makes them quite useful for filling in the gaps in a portfolio. If you are trying to build a truly diversified portfolio, but cannot find an actively-managed fund that you like to fill a certain role in the portfolio, there is probably an ETF that can do the job.

ETFs can also be used by active fund managers themselves to “equitize cash.” Sometimes a money manager (or individual investor) may get some significant inflows of assets to invest, but currently doesn’t have the ideas or the ability to put all that cash to work in specific individual securities. If the fund wants to be fully invested, they can quickly buy an ETF and get the market exposure they desire. For example, Fidelity’s Mid Cap Growth fund has nearly doubled its asset base in 2005, and Manager Bahaa Fam has made use of an ETF — IShares Russell Midcap Growth — to put a portion of that sharp increase to work fast and keep the funds holdings of cash to just 1%.

Sophisticated managers, including many hedge fund managers, will “short” ETFs. This means they actually sell the securities before they actually buy them. While this maneuver can be used as an outright market call, it is also often used as a “hedge.” For instance, a hedge fund manager may have a large position in small cap stocks. Even though this manager may be a very good stock-picker, they are also taking on considerable market risk, and particularly to the small cap area of the market. If they want the fund’s return to be primarily driven by stock selection rather than market direction, they could short a small cap ETF. This will help offset the impact of market fluctuations in small caps.

Potential Dangers To Avoid
Like any other investment vehicle, improper use can lead to trouble. This brings us to the biggest problem I see with ETFs: the temptation to chase performance. As the studies we have mentioned in the past have pointed out, the biggest problem impacting investor returns is the basic investor behavior of buying what has already gone up and selling what has already gone down. Granted all types of investors chase performance, including mutual fund investors, but the seductive appeal of apparently cheap, style pure ETFs that can be traded at all hours will only encourage the short-term pursuit of the market's “hot dots.” Just look at the asset flows into ETFs. Generally speaking, they are going to areas of the market that have been doing well. This is a sign of chasing short-term performance.

A related problem of being able to trade ETFs like stocks is that it obviously becomes much easier to monitor and trade one’s portfolio. Looking at prices in real-time can create more emotional responses and trading activity. Neither is healthy for investment success. Generally speaking, investors who decrease the frequency of how often they monitor their investments generally do better. They don't “adjust” their portfolios at every market wiggle or sensational headline; they just stay the course.

And, if you do trade more frequently, there are costs incurred in buying or selling that you don’t have with a no-load, no-transaction fee mutual fund for instance. First, like a stock, each time you buy or sell an ETF, you incur a commission to be paid to the broker. Second, there is the additional “spread” cost (the difference between the bid and ask prices). Active traders may think they are saving money due to the ETFs' relatively low underlying expense ratios, but transaction costs will nickel and dime their returns lower.

These additional transaction costs also make dollar-cost averaging difficult to implement. Many mutual fund investors systematically invest a certain amount each month. Using ETFs, however, means that transaction costs have to be paid each time. Again, no-load, no transaction fee funds will not have that problem.

In addition, while an individual ETF may be tax efficient, that doesn't mean that an investor in ETFs will be tax efficient. This is a critical distinction that is often lost in the industry. A truly tax-aware investor, sometimes even using tax inefficient vehicles, can often be more tax efficient than an investor using all tax efficient products. Ultimately, tax efficiency is about many things, such as the frequency of trading, awareness of holding periods, utilizing tax harvesting and swap strategies, and avoiding distributions, among others. An investor actively trading ETFs with no consideration of taxes will surely generate plenty of taxable events and not necessarily positive ones either.

Summary
In sum, we think ETFs are an excellent addition to the industry. They not only have appealing features, but they can be used in many interesting ways (I’ll save the debate on active versus passive management for another time). That said, like many other things in life, nothing is perfect and ETFs are no exception. While many money managers are using ETFs in reasonable and appropriate ways, it is a bit maddening to see so many people in or associated with the investment industry, be it journalists or money managers, claim that portfolios of ETFs are the way to go primarily because of the low costs — yet the very portfolios they suggest are essentially short-term trading vehicles that smack of performance chasing. While costs are indeed an important consideration in maximizing investment returns, not having the discipline to maintain diversified portfolios is much more destructive to creating and maintaining long-term wealth.

Sincerely,

Rusty Vanneman, CFA
Director of Research
Co-Portfolio Manager