This is not your father’s asset class

All generations lay claim to things they consider cool. In the investment world, exchange-traded funds are the stuff of millennials.

ETFs are “millennials’ version of their parents’ mutual funds,” said certified financial planner Douglas Kobak, a senior advisor and principal of Main Line Group Wealth Management. “The word has become synonymous with investing.”

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But, as Kobak and other financial advisors caution, all investment products come with advantages and disadvantages. And because the potential downsides of ETFs might escape casual inspection, they should be vetted as thoroughly as any mutual fund.

“You have to do your homework with both,” Kobak said, whose clients typically have about 80 percent of their portfolio in ETFs.

There’s no question that investors’ romance with ETFs has continued unabated. While traditional, open-end mutual funds saw roughly $153 billion in outflows this year through August, ETFs reeled in nearly $142 billion of new money, according to investment research firm Morningstar.

Separate research suggests that millennials — who now represent the largest generation in America, at more than 75 million strong — are driving much of the ETF love.

Charles Schwab’s 2015 ETF Investor Study revealed younger adult investors (those ages 18 to 35) have 41 percent of their portfolios in ETFs, compared with 25 percent of Generation Xers and 17 percent of baby boomers.

Moreover, the study shows that 70 percent of millennials see ETFs becoming their core investment type in the future. That compares with 46 percent of Gen Xers and 24 percent of boomers.

For fans of ETFs, the benefits are no-brainers.

For starters, they generally boast lower costs. Morningstar data show the average expense ratio for all ETFs is 0.56 percent, compared with 1.18 percent for traditional mutual funds if you include both actively managed (professional fund managers pick the investments) and passively managed (think index funds).

Even actively managed ETFs — of which there are fewer than 60 — come with a lower price tag. Their average expense ratio is 0.77 percent, compared with 1.2 percent among actively managed mutual funds, which number in the thousands.

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“Millennials are probably more savvy about fees because so much has been written about it,” said George Gagliardi, a financial advisor and founder of Coromandel Wealth Management. “The information is out there, and they can find it.”

Which brings us to transparency. Mutual funds can appear secretive compared with ETFs: Traditional mutual funds are only required to disclose their holdings quarterly with a 30-day grace period. Investors can view a typical ETF’s holdings online any time they want.

“Every day I can look at what’s in an ETF,” said Gagliardi, who also uses ETFs for about 80 percent of a typical client portfolio. “I don’t have to … wait for a report that comes out some time after the quarter has ended.”

ETFs also come with better liquidity. Unlike traditional mutual fund shares, which can be redeemed just once a day, ETF shares trade throughout the day like stocks.

They also are more tax-efficient. Even when held in taxable accounts, they generate no capital gains as many traditional mutual funds are prone to do.

All sounds great, right? Definitely. But there are other considerations. For starters, low fees do not automatically translate into strong gains. Any fund — whether an ETF or traditional mutual fund — can only perform as well as its underlying investments. If you are invested in an ETF that tracks a tanking index, your ETF tanks, too.

In theory, in actively managed mutual funds, fund managers can rearrange their mix of holdings to avoid huge losses. While that doesn’t always go as planned, it’s possible to find actively managed funds that consistently outperform their benchmark. That’s something that could bode well in a bad market environment.

Gagliardi, for instance, said he has a “strong preference” for active management in some areas, including certain bond categories, emerging market stocks, and microcap and small-cap equities.

Another unanticipated problem can come with stop-loss orders. Basically, if you have an automated sell order in place for when and if the ETF drops to a certain price, your shares will be sold even if the ETF is temporarily trading at a discount to its underlying investments and corrects itself later in the trading day.

“An investor can be stopped out [moved to cash] even though the index did not drop as much as the ETF,” said CFP Mark LaSpisa, president and managing advisor at Vermillion Financial Advisors. “This can cause huge losses and tax ramifications.”

“You have to look inside these ETFs and see what they hold. I’m a big fan of them, but I always look them over carefully.”-George Gagliardi, founder of Coromandel Wealth Management

The reasons for this are complicated, but suffice it to say that stop-loss orders might be inappropriate for your ETFs.

Financial advisors also stress that when evaluating ETFs, two that have similar names might have decidedly different holdings at different weightings. And, their performances could vary wildly.

Morningstar, for its part, hopes to make it easier for investors and advisors to compare ETFs not only to each other, but to traditional mutual funds. On Nov. 1, the company rolled out forward-looking analyst ratings on roughly 250 ETFs listed around the world, more than 100 of which are U.S.-based.

The point, according to Morningstar, is to allow investors to more easily compare ETFs to mutual funds when they are in the same investment space.

Many advisors already make those comparisons, and the choices they make typically boils down to bottom-line returns for clients.

LaSpisa puts it this way: “An active manager is supposed to provide more value and hopefully give me better performance. If I can’t find a mutual fund that does that, I might as well use an ETF.”

Of course, ETFs — like any investment — are not foolproof. Literally. Various research shows that yanking your money from the market right after a portfolio value drop ends up hurting you — sometimes significantly — down the road.

Nevertheless, this is what we humans do. Financial advisors say this penchant for running from losses is as likely to happen with ETFs as it is with any other investment.

And, advisors say, any investment is a case of buyer beware.

“There are cases where a passive strategy or formula has had disastrous results,” said Gagliardi at Coromandel Wealth Management. “You have to look inside these ETFs and see what they hold. I’m a big fan of them, but I always look them over carefully.”

— By Sarah O’Brien, special to CNBC.com

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