Do I Need ETFs in My Portfolio?

With the surging popularity of exchange-traded funds, many investors feel that if they don't own ETFs, they must be missing out. Not so.

There are many distinct advantages to ETFs--they are generally low cost and help hands-on traders take more direct control of their portfolios--but there is no disadvantage to not owning them. If you are comfortable with your current allocation to stocks, bonds, or mutual funds, don't feel pressured to rush into ETFs. But if you are invested in a number of high-cost mutual funds or you enjoy trading individual stocks, ETFs are worth considering.

So where might ETFs fit into your portfolio? First, some preliminaries.

Asset allocation--how to diversify your portfolio between stocks, bonds, and other assets, and how much risk to take on--is the fundamental decision facing all investors. It is important to spend the time, either on your own or with an advisor, to make sure you are comfortable with your asset allocation and the impact your decision will have on your future wealth under various scenarios. The way you divide assets between safer investments, such as high-quality bonds, and higher-risk/higher-reward assets, such as equities, will go a long way toward explaining your portfolio's performance and the amount of sleep you get at night.

Although stocks have outperformed bonds over the long term, they are much more volatile. Over short periods of time, not only can stocks underperform bonds, but a large allocation to stocks can result in a significant loss of principal. For those who depend on their portfolios to cover their immediate living expenses, such a loss can be devastating. This is the reasoning behind such rules of thumb as, "the percentage of your portfolio invested in bonds should be equal to your age." As we near retirement, such practices will ensure that less of our portfolio is exposed to the risk of large losses.

The asset allocations in your portfolio are likely distinct from the investment vehicles you choose to get exposure to those asset types. Stocks of corporations listed on an exchange and government bonds are primary investment vehicles, and each is a separate asset class. ETFs, on the other hand, are access vehicles with which to gain exposure to various asset classes. Just like a mutual fund, most ETFs give investors an ownership interest in a portfolio of securities, including many stocks and bonds. Other ETFs target areas of the market where there are few, if any, mutual fund choices. For example, there are non-diversified ETFs that own derivative contracts on commodities or currencies

Although different access vehicles may have different costs and different traits, it's the underlying holdings of those vehicles--stocks, bonds, commodities, etc.--that determines your portfolio's asset allocation. 

The benefits of owning ETFs are similar to the benefits of owning mutual funds. They offer a low-cost way to gain diversification without having to buy hundreds of individual stocks or bonds. But while ETFs are similar to mutual funds in many respects, there are some differences. Whereas mutual funds are bought and sold directly with the fund company at the end of day's net asset value, ETFs are traded throughout the day on an exchange, just like a stock.

ETFs generally have lower expense ratios than mutual funds--and expense ratios are a key determinant of performance--but trading costs with an ETF will be higher. While mutual funds tend to be actively managed, giving investors access to professional money managers, ETFs tend to follow an index. This index may be passive, such as the S&P 500, or it may reflect a strategy, such as buying only dividend-paying stocks or front-month futures contracts. It is important to understand both the exposure that an ETF is attempting to provide and the implementation strategy that it follows.

If your portfolio consists primarily of mutual funds, you may want to compare the cost of those mutual funds and the aggregate exposure they provide to see if you can get equivalent exposure with lower cost through ETFs. Low-cost ETFs could form the core of your portfolio, while higher-cost active managers could be used as satellite holdings, for example.

If you are a more active investor who prefers to do your own stock research and trading, you may benefit from the variety of ETFs that give targeted exposure to different areas of the market with the ability to trade them freely.

If you have no interest in trading and are content with your current portfolio and its fee structure, there is no need to buy ETFs. If you use an advisor, you may want to ask if he or she has considered the cost benefits of ETFs versus similar mutual funds that you may already own.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.