Rules of the Game: Popular ETFs

 | Jun 13, 2013 | 12:00 PM EDT
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According to a survey conducted late last year by the Investment Company Institute, 43% of financial advisors believe exchange-traded funds will outpace mutual funds within the next decade.

The pace of ETF inflows picked up in 2012, and analysts expect that trend to continue this year.

Let's take a little trip back in time. The first ETF was introduced on the Toronto Stock Exchange in 1989. In their early days, these were seen as trading vehicles, not investments. The big kahuna of ETFs, the SPDR S&P 500 ETF (SPY), made its debut in 1993.

Why were ETFs invented, anyway? The answer might surprise you. Stock exchanges wanted more business from speculators who wanted to trade indices. Nothing to do with making life simpler for retail investors, who wanted things streamlined. It was all about grabbing market share from futures exchanges.

They are now mainstays in many individual investors' portfolios because they are cheap, tax efficient and unlike mutual funds are tradable during market hours. We use ETFs in client portfolios for these reasons.

But not all ETFs are created equal. Companies package and market ETFs as the answer to long-term investing, short-term trading and speculative bets on commodities, or even to mimic the attributes of hedge funds.

In addition, there is now a raft of ETFs that short indices with double or triple leverage. I coached individuals in trading strategies for several years. For the at-home trader, these leveraged ETFs were popular ways to attempt to outsmart the market.

Even the companies that market these vehicles readily acknowledge that they are not intended as holds, but as short-term trades. Nonetheless, I've repeatedly seen do-it-yourselfers hang on too long, and lose the effect they were trying to get.

Don't kid yourself: The pros on Wall Street don't use leveraged, inverse ETFs. They are marketed to retail traders, not professionals.

But wait.  There's more! Plenty of investors believe ETFs are safe, or at least mainstream, because they are pegged to indices. But just as I noted above that all ETFs are not created equal, neither are all indices.

It hasn't been possible to translate every sector of the market into a successful ETF. For a glimpse of what I mean, just look at the Global X Junior Miners ETF (JUNR). It's pegged to the Solactive Junior Miners Index, which was created by a company called Structured Solutions specifically for use by ETFs.

It's not at all uncommon for new ETFs to be launched with the intention of tracking an index developed just for that purpose. There's nothing inherently wrong with this, but keep in mind what an index is: It's simply a way of benchmarking certain assets against the market. It provides a reference point. How easy is it to use the S&P 500 as the proxy for the U.S. market? It's undoubtedly a handy tool.

But outside of the major indices, it's not easy to find viable ETF investment ideas. In addition, in 2008 the ETF allowed actively-managed ETFs -- kind of defeating the purpose for investors who want greater efficiency than they can get in mutual funds.

What's the upshot? Do your homework when shopping for ETFs. As I mentioned, I like these vehicles for their cost efficiency and ease of trading, but use them with care!

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