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By Christine Benz and Paul Justice, CFA | 06-12-2012 01:30 PM

Some Assets a Better Fit for ETFs Than Others

ETFs can be great vehicles for accessing core, liquid areas of the market, but they have more issues in MLPs and illiquid underlying assets, like high-yield bonds.

Christine Benz: Hi, I am Christine Benz for Morningstar.

Exchange-traded funds have taken off in popularity because they enable investors to build well-diversified portfolios at a very low cost, but not all investment categories lend themselves well to the ETF format.

Joining me to discuss that issue is Paul Justice. He is director of exchange-traded fund research for Morningstar.

Paul, thank you so much for being here.

Paul Justice: It’s great to be here. Thanks.

Benz: Paul, let’s start with the categories where you say investors should just go ahead; they lend themselves very well to the ETF format. What would those be?

Justice: I think those are the areas you've already identified as the core of your portfolio. So, large-cap equities, we naturally saw the ETF landscape evolve from that starting point. Things that have very liquid underlying tend to be good performers in the ETF structure. Large-cap equities, even credit-grade bonds would be a great place to go.

Benz: So higher-quality bonds.

Justice: Higher quality, the ones that already have a very developed market for them, that people are often participating in the market, making sure they're trading well. Even across borders, this still applies. It doesn't just have to be domestic equities; it could be international equities, and it could be investment-grade bonds outside of the United States. ETFs have done really well there.

Benz: So, Paul, ETFs can even work in areas where investors might have some preconceived notions that they are better off with actively managed funds, and you note that emerging markets is actually one space where investors can successfully invest in ETFs.

Justice: Certainly. Emerging-market funds have done fantastically well in the ETF structure. Not only have they garnered hundreds of billions of dollars in assets, they’ve performed very well. Many of the top-performing funds in the entire emerging-market category are in fact ETFs. It's some of the top 10 funds there, and they are passive by nature, they keep costs low, and it might surprise some people.

I think oftentimes when people venture outside of their circle of competence, what they are familiar with, you have that home bias, you know domestic equities really well, and you get comfortable with passive there. When you go outside into emerging markets, it seems exotic. It feels like something you don't know much about. You may tell yourself that you need the stewardship of an active manager to really navigate that landscape, and it's not necessarily the case. The low-cost passive ETFs have done very well there.

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