ETFs: The Funds from Outer Space

As my colleague Russel Kinnel pointed out last week, exchange-traded funds are running rampant. Not only are they growing in number and assets, but they have become almost omnipresent, with enthusiastic advertisements in print, broadcast, and digital media. You'd think every man, woman, and child on earth would have heard about them by now, yet I still hear from a lot of people who know little more about ETFs than my soon-to-be-12-year-old son, who refers to them as Extraterrestrial Funds. For those who still regard ETFs as something alien, here's a quick primer as well as some suggestions for analyzing them and working them into your investment mix.

The Basics
ETFs are essentially mutual funds that can be bought and sold throughout the day like stocks on an exchange through a broker. Consequently, unlike conventional mutual funds, ETF share prices are determined throughout the day by supply and demand. In contrast, conventional funds are priced at their net asset values, which are compiled once per day at 4 p.m. EST. Anything you can do with a stock you can do with an ETF: You can sell them short (or sell borrowed shares with the intention of buying them back at a lower price and pocketing the difference), write options on many of them, and set market, limit, and stop-loss orders on them.

How They work
Most individual investors never deal directly with an ETF the way they would with a traditional mutual fund. Individuals and financial planners buy and sell ETFs among themselves via a broker. In this way, they are similar to closed-end funds. But the similarities end there. Closed-end fund shares can trade at large premiums or discounts to the net asset values of their underlying portfolios. ETF discounts and premiums tend to be much smaller, though, because ETFs can do something closed-end funds can't: continuously create and redeem shares in-kind. This means that the ETFs exchange fund shares for baskets of their underlying securities and vice versa.

This in-kind creation/redemption process creates an arbitrage opportunity for large institutional investors and market makers, known as authorized participants, who deal directly with the ETF. This helps keep ETF premiums and discounts narrow. When ETF shares trade at a discount to the NAVs of their underlying holdings, the APs buy the ETF shares and sell the underlying securities. If the ETF shares trade at a premium, the APs buy the underlying securities and sell the ETF shares. In the process of taking advantage of these arbitrage opportunities, the APs drive ETF market prices and NAVs close together.

Advantages
As you might guess, the ETF's flexibility is one of its key attractions. Many institutional and individual investors have been drawn to the ability to pick their own entry and exit prices, as well as the chance to use fund portfolios in various trading and hedging strategies. Another advantage is transparency. Because all ETFs currently are index funds, its easy to know what you own. ETFs also come in more-exotic flavors. While conventional mutual funds still vastly outnumber ETFs, funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments, such as currencies, precious metals, or emergent industries, that heretofore have been the sole province of larger institutional and wealthy investors.

From Morningstar's (typically long-term) viewpoint, though, low expenses and tax efficiency are the most attractive features of ETFs. They are able to offer much lower expense ratios than conventional mutual funds because they're index funds that typically don't hire professional (and often expensive) researchers and stock-pickers in an effort to beat the market. Furthermore, because investors purchase ETFs via a broker on the open market instead of from the fund companies, the ETFs don't have all the record-keeping and shareholder-servicing costs that conventional mutual funds incur.

When it comes to taxes, the ETF structure has a lot of advantages, too. Index funds in general tend to be more tax-efficient than actively managed funds because they don't trade as often. The in-kind creation/redemption mechanism also gives ETFs additional tools to sidestep capital gains. Because no one redeems their fund shares for cash, ETFs don't have to sell securities to pay off departing shareholders. Furthermore, ETFs can use in-kind redemptions to flush low-cost basis shares out of the portfolio, thereby reducing the chance of realizing capital gains when the ETFs have to sell securities to keep up with changes in their benchmarks.

Disadvantages
There are hidden costs to ETFs. They can be more costly to use than conventional mutual funds after you factor in commissions. You can find discount brokerages, but even there transaction costs can pile up quickly and negate the ETF's expense advantage if you trade frequently or make regular monthly investments. Many brokerages also saddle account holders with additional account maintenance, inactivity, and minimum balance fees. And don't forget the bid/ask spread, or the difference between the price you offer to pay for an ETF share and what the market is willing to give you. ETFs spreads often are fairly tight, but that is still an additional cost you don't incur with traditional funds.

Lastly, ETFs, especially very narrow ones, are prone to be misused. Many of the more specialized offerings are concentrated and volatile. This is troublesome because sector ETFs also tend to be more volatile as measured by standard deviation, and past studies we've done on investor returns show that investors don't tend to use volatile funds well. Furthermore, there have been dozens of ETFs launched in areas that have experienced hot returns in recent years, such as oil, gold, other commodities, and emerging markets, which encourages performance chasing.

How to Use ETFs
The ability to trade, short, and buy ETFs on margin is alluring, but these are speculative tactics that require accurate short-term market calls, which few, if any, can get right consistently over the long term. Similarly, market-timing and sector-rotation strategies don't get any easier just because you use ETFs to implement them.

Core and explore approaches, which involve using diversified funds or ETFs as your portfolio cornerstones and deploying more specialized ETFs around its edges to enhance returns, seem reasonable. But they require strict discipline and attention to detail lest you sabotage yourself with increased complexity and costs.

As usual, it's best to keep it simple. The simplest way to use ETFs is for a lump-sum, buy-and-hold investment. For example, if you've decided to go aggressive and put 80% of your money in stocks and 20% in bonds, you could use the  Vanguard Total Stock Market ETF (VTI) for the equity portion and the  iShares Lehman Aggregate Bond (AGG), which tracks virtually the entire bond market, for your helping of fixed income. If you're an even more adventurous sort, you could throw in the  iShares MSCI EAFE Index (EFA), which tracks most of the major developed markets outside of the United States, or even a smidgen of the  Vanguard Emerging Markets Stock ETF  (VWO). Even simpler total international exposure can be had from Vanguard FTSE All-World ex-USA Index Fund (VEU) and SPDR MSCI All Country World Index (CWI).

You can also resort to ETFs when the conventional mutual fund options in a given category tend to be limited, expensive, and run by managers with short tenures. For example, in the some of the small-cap categories, conventional funds with decent expenses, managers, strategies, and track records often close soon after investors discover them. ETFs can be a viable alternative in this area.

Analyze This
As you sort through the burgeoning list of ETFs, don't forget to pay attention to fundamentals. There is no reason you shouldn't apply many of the same standards that you would to a conventional fund to ETFs. Understanding a funds' management, expenses, taxes, strategy, risk/reward profile, and long-term record should lead you to decent options.

ETFs are innovative tools that can help investors reach their goals in a variety of ways. You can use them to manage risk, taxes, and style, region, and sector exposures. ETFs, however, can also do some damage if you're not careful. As always, know what you own and keep trading and commission costs to a minimum.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.