So you’ve decided exchange-traded funds sound like a great way to build a low-cost investment portfolio. The question is, what now?
Financial advisors say that before you start buying ETFs, it’s important to fully grasp their nuances, because like any investment, they are far from risk-free.
“Any time you’re investing in an ETF, whatever happens inside that ETF’s sector will expose you to risk,” said Pete Lang, president of Lang Capital. “They [generally] are not actively managed.
“No one is steering that ship,” he added. “You’re investing in an index, and that’s a higher-risk proposition due to potential volatility.”
Once considered a niche product, ETFs have emerged as a dark horse in the race for investor money. With an increased investor focus on costs, coupled with a long-running bull market contributing to gains in many index-based investment options, ETFs are pulling in more assets than traditional mutual funds.
In 2016 investors poured $287 billion into ETFs while they pulled nearly $349 billion out of traditional actively managed mutual funds, according to research firm Morningstar. Index funds fared better, grabbing almost $221 billion in new investor money last year.
But with more than 1,900 ETFs available and new ones hitting the market continually, the question for some investors is how to choose which ones to include on the shortlist.
The first thing to do is make sure you don’t put all your eggs in one basket.
“Make sure you’re adequately diversified globally and among asset classes,” said certified financial planner George Gagliardi, a financial advisor with Coromandel Wealth Management. “You don’t want everything in your portfolio to move in lockstep together.”
For instance, if you choose only an ETF that tracks the Standard & Poor’s 500 Index and then U.S. stocks hit the skids, so will your entire portfolio.
And at that point, if you have neglected to properly vet yourself for your risk tolerance (your ability to stomach market turbulence) and risk horizon (the length of time until you need the money), you run the risk of selling at a loss if you can’t sit still and wait to see if it’s a quick dip or a long-lasting bear market.
“There have been periods where the market has been down two years in a row and it can take five or more years to get back to where you were before,” Gagliardi said. “You want to have upside gains, but be careful that you don’t get overconfident in a rising market.”
This is not to say, however, that you should avoid U.S. stocks. It’s just that global diversification matters.
To determine exactly how much of your money should be in domestic ETFs , as opposed to international ones, advisors say you first need to figure out your asset allocation and diversification strategy.
Asset allocation is how you divvy up your holdings among general asset classes, including stocks, bonds and cash. Generally speaking, the closer you are to needing the money, the less risk you should have in your portfolio.
The next step is to make sure your portfolio is adequately diversified within those asset classes. Choosing exactly how to do that means doing your homework, given that it involves trying to capitalize on economic trends that can affect various sectors differently.
Gagliardi, for instance, would recommend that if a person had 60 percent of his or her portfolio in stocks, that share currently should be equally divided among ETFs representing emerging markets, developed countries and U.S. stocks, due to Gagliardi’s belief that most of the growth going forward will be overseas.
“Investors should ask themselves when a focus of an ETF might become too narrow.”
He also said that for bonds, he prefers ETFs that are actively managed despite the slightly higher cost than a pure-play bond index ETF.
“I don’t mind paying a little extra to have someone’s hand on the tiller,” Gagliardi said.
Cost is one of the reasons for ETFs’ popularity. Morningstar data show the average expense ratio for all ETFs is 0.56 percent, compared with 1.19 percent for actively managed mutual funds and 0.82 percent for index funds.
For many categories of ETF investments — those that are heavily traded and track a popular index — comparing costs is the easiest way to pick which fund gets to represent. But advisors say to look beyond the expense ratio and consider any brokerage costs involved in making trades.
For ETFs that are more esoteric or thinly traded, advisors warn “Buyer beware.”
Danger: Fold or get rolled
“Investors should ask themselves when a focus of an ETF might become too narrow,” said Laura Stover, an investment advisor with LS Wealth Management.
Among the dangers in a thinly traded ETF, advisors say, is that it will fail to attract enough investor interest and consequently fold or get rolled into another ETF.
Advisors also caution that while ETFs often get props for their tax efficiency due to no distribution of capital gains, there are exceptions.
For instance, ETFs that are leveraged (trade at multiples of the index’s performance) or inverse (trade at inverse multiples) rely on buying and selling derivatives to meet their daily goal. Those transactions can generate capital gains.