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By Paul Justice, CFA | 03-30-2011 04:47 PM

When Do ETFs Work Well? When Do They Struggle?

Morningstar's Paul Justice and Sam Lee discuss what types of ETFs work well for investors and when they might want to look at other investment vehicles, such as active mutual funds or closed-end funds.

Paul Justice: Hi. I am Paul Justice of Morningstar, the director of our ETF research in North America.

Today, we're going to talk about the ETF structure, and when it works and when it might not, and some of the challenges that you might face.

Today, I am joined by Sam Lee, one of our ETF analysts, who has been evaluating the structure question and really digging deep in understanding what ETFs are going to work well for people and when you might want to look at maybe a mutual fund, a closed-end fund, or the underlying securities in particular.

So, if you don't mind, let's jump right off and really talk about, what are some of the attributes of underlying securities that makes an ETF work well?

Samuel Lee: Well, the first are the basics. The ETF has to deal with the securities that trade in deep and liquid markets, and what we mean by deep markets, we mean there is a lot of volume in there, a lot of active players, who are making sure that the price of the underlying securities are somewhat fair. So, the ETF doesn't actually influence the prices.

Justice: So, like large caps, domestic stocks will be a great starting point where the ETF...

Lee: International stocks, Treasury bonds, those are perfect for ETFs.

Justice: So, we get a lot of trading volume in there. It makes it easier for some of the institutions to go ahead and do the creations, redemptions necessary, really reflects the liquidity of the ETF. So, it could be a small ETF, but if you got the liquid underlying, it's probably going to work pretty well.

Lee: It's going to work excellent. So, even if it's $5 million in an ETF, if it deals with U.S. Treasuries, it's still going to be really good if you are simply entering your purchase orders with limit orders.

Justice: Pretty close to whatever the fair value is listed by the indicative value index published every 15 seconds.

Lee: Yes

Justice: Okay. So what are some areas that we should be concerned about, because we've got nearly 1,200 exchange traded products today, and seemingly new asset classes introduced all the time. What do you think are some of the ones that could face challenges down the road?

Lee: So these are not really a big part of the ETF market, thankfully, but they are ETFs that deal with less liquid, less trafficked securities, so on big example is micro-caps.

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