These days people are talking about how to invest in ETFs and exchange-traded funds (ETFs) are all the rage. An ETF is a group of assets—stocks, bonds, futures, commodities, and currencies—that are traded as a package. In that way, ETFs are a lot like mutual funds.
There are big differences between ETFs and mutual funds, however. ETFs are traded just like stocks—the price adjusts in real time. What’s more, when you invest in a mutual fund, you might pay a penalty for selling your shares early—usually you’re expected to hold the fund for at last 90 days. You also need to pay fees to the company that manages the fund.
There are about 70 companies that create ETFs for U.S. stock markets. Just four of those—BlackRock, Vanguard, State Street, and Invesco PowerShares—have created nearly 90% of current ETF assets. But while these companies create ETFs, they don’t manage them.
Many investors are choosing ETFs over mutual funds for that reason: No fees. There’s evidence that when offered two identical funds, investors are likely to choose the one that charges the lowest fees.
Every investor wants to be in the driver’s seat, and ETFs promise that. No dealing with managers, no penalties, no brokerage fees. Just the investor wheeling and dealing on the stock market. There’s also an option for every investor.
No wonder ETFs are so popular. As of July 2017, total investment in ETFs had risen for 16 consecutive months. At the beginning of 2017, they accounted for about 23% of total share volume. Total U.S. ETFs recently topped $3 trillion. That’s amazing, considering that few investors knew about them a few years ago.
ETFs were once a small player in the stock trading game. Now, they’re rewriting the rules. It’s time to consider whether you want to invest in ETFs yourself.
Why Not Invest in ETFs?
ETFs are exciting and easy to trade, but the risks are real. An ETF is a package, so the underlying assets—stocks, bonds, or whatever—can’t be traded individually.
That means that bad assets get mixed in with good ones—and because they’re not traded individually but as part of the ETF, the prices of those bad assets get distorted.
Also, certain stocks get over-owned because they’re included in some of the bigger ETFs. For example, 11 major stocks have received 16.2% of total ETF equity investment in 2017, even though they account for only 13.9% of total market capitalization. That could be a bubble starting to form.
ETFs are also more volatile than many investors think. Just because it’s a package of different assets doesn’t mean it’s not risky. For example, many ETFs track a specific industry or sector, such as oil, tech, or emerging markets. A slowdown in that sector can cause the ETF to lose value.
How to Play the ETF Game
There’s risk involved, but you can make money if you invest in ETFs. It starts by doing your homework. Don’t just look at how the ETF is performing as a whole, look at each asset individually. How much risk do they carry?
For example, consider the iShares MSCI Emerging Markets ETF (EEM). The index has done well in 2017, gaining 23% since January 3. Many of its underlying stocks look strong.
The Emerging Markets ETF is less diversified than it looks, however. Six of its 10 largest assets by weight are based in China. Of the remaining, two are in Taiwan (Taiwan Semiconductor and Hon Hai Precision Industry) and one in Korea (Samsung). This ETF is heavily dependent on China’s economy.
That doesn’t mean you shouldn’t invest in the Emerging Markets ETF. It just means that betting on this ETF to a large degree means betting on a specific country. Make sure that’s a bet you’re willing to make.
Smart investing in ETFs is like smart investing in anything else: Do your homework.