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Exchange-traded funds are the hot investment choice nowadays. But before you buy, know that these vehicles have downsides, too.
ETFs continue to gain ground as an investment of choice among many individual and institutional investors, with record issuance in 2012, worth $185 billion. ETFs are similar to mutual funds in that they are pools of individual securities, and to closed-end funds, which trade on a stock exchange like individual shares.
Despite the instruments’ popularity, investors often misunderstand them. Here are five things you should know about ETFs.
1. Not all ETFs use conventional underlying benchmarks. The first ETFs were largely index products, such as the SPDR S&P 500 (SPY), which tracks the S&P 500 index. SPY remains one of the most traded ETFs, day and day out.
An ETF like SPY is pretty easy to understand. The underlying holdings mirror the S&P 500 index and performance generally tracks the index less the ETF’s expenses (0.09% according to Morningstar).
With the popularity of ETFs, the growth and proliferation of new vehicles is quite high. Many of these new ETFs track some funky benchmarks. Market Watch’s Chuck Jaffe cited a Vanguard report that found “1,400 U.S.-listed ETFs track more than 1,000 different indexes. But more than half of these benchmarks had existed for less than six months before an ETF came along to track it.”
I suspect this issue will become more prevalent as ETF providers continue to introduce new entries in a bid to capture market share and assets.
2. Some ETFs are based on fads or gimmicks. The Winklevoss twins (of Facebook fame) recently announced the proposed launch of a new ETF tracking bitcoins. These are a virtual currency that exists outside of governmental regulation. The ETF faces many hurdles and may never get off of the ground.