Loads of new concepts have become trendy in the past few years: CrossFit, bright pants, Katy Perry documentaries.
The wisdom of some of these trends is questionable. (Orange jeans? Really?) But the explosion in popularity of index funds and exchange-traded funds is definitely one of society’s better moves.
Unless you’ve been living under a rock, you already know that index funds and ETFs are low-cost alternatives to expensive actively managed funds. They allow you to keep more of your money in your own portfolio, instead of feeding some suit-and-tie’s nest egg.
That’s why more than $122 billion in new funds flowed into equity ETFs between mid-2009 to mid-2011, according to the Wall Street Journal. Compare this to the trend in mutual fund during the same time period: investors were selling them like hotcakes during that same era, to the tune of a $33 billion outflow.
Bottom line: ETFs and index funds, good. You know that. You get it.
But index funds and ETFs have gained so much popularity in recent years that now there are offerings for every niche and sector.
Index funds and ETFs now represent a wide-ranging assortment of sectors, regions, countries and investment styles. They span sectors as varied as health care, utilities, precious metals, finance, and global energy, to name just a few. Investors can buy indexes or ETFs tracking small-caps in Japan, financials in Brazil or high-dividend kings in Great Britain.
The structure of index funds – which are bought and sold at the end of the trading day, like mutual funds – keep the trading possibilities at bay. The ETF world is far wilder.
ETFs trade on the market in real-time, just as a stock does. As a result, investors have created every form of ETF imaginable to serve as a minute-by-minute trading tool. For example, here are three product variations of ETFs:
* Inverse ETFs allow traders to “short” the underlying index, which is market-speak for “place a bet that the index will fall, rather than rise.”
* Leveraged ETFs double or triple the underlying indexes’ gain or loss; a 1 percent gain in the underlying index results in a 2 percent gain for a leveraged ETF.
* Actively-managed ETFs – no, that’s not a typo — are presumably for investors who are feeling nostalgic for high fees.
How should you handle this enormous platter of choices? Should you stick to broad-market index funds and ETFs? Or should you try the hottest sector-specific fund?
Should you stick with direct ETFs? Or should you take a gamble on inverse or leveraged ETFs?
What Should I Do?
Heed this: Sector-specific funds are specialized arenas that carry extra risk, as compared with a diversified broad-sector fund.
Are you an expert in precious metals – or did you just glance at the headlines and see that the price of gold is up this week?
Do you read Restructuring Today, Utility Week and other utilities trade publications? Or do you simply think your gas bill is too high?
Your answers to those questions should guide your decision about whether to leap into a sector fund or not.
Meanwhile, inverse and leveraged ETFs are trading tools for day-to-day speculators, not long-term investors. Don’t be lulled by the ETF acronym – these vehicles carry substantial risk.
You’ll also pay sky-high fees for inverse and leveraged ETFs, just as you do for actively-managed ETFs. The UltraShort FTSE China 25, for example, an inverse ETF tracking the largest 25 Chinese stocks, carries an expense ratio of 0.95. That means nearly 1 percent of your investment is gobbled by fees, regardless of whether you walk away with a net gain or loss.
The Bottom Line
Don’t venture into those fields without doing your homework first.
If you want to venture into inverse and leveraged ETFs, remember that you’re making the decision to be a day trader and speculator. You’ll be carrying as much risk as the pit traders who buy calls and puts. (If you don’t know what that means, stay away from inverse and leveraged ETFs).
If you decide to leap into the shark tank, well, you’re an adult. I can’t stop you. But I can recommend that you buckle down, study hard, talk to other investors, and test-drive your plays as paper trades for the first few months.
If you want a tried-and-true, long-term investment strategy, don’t get distracted by the glitz and glamour. Stick with broad-sector funds, allocated based on your age and risk tolerance.
And for Pete’s sake, throw away those orange jeans.