3 whys for ETF
Despite being on the market for over 20 years, many investors still don’t understand the basics of Exchange-Traded Funds (ETFs). These increasingly popular investment vehicles still seem scary to many investors, while others feel as though ETFs are just snazzier mutual funds that have no place in a stock investor’s portfolio.
This really couldn’t be further from the truth.
Below, I’m going to highlight three of the basic questions that most investors don’t know or get wrong about the ETF world, along with answers to each. Hopefully this will shed some light on the space and help to dispel some of the many myths circulating about ETFs to this day:
1) ETFs Only Focus on Major Indexes, Right?
While there is a ton of capital in ultra-popular ETFs targeting major indexes like the S&P 500 or the Nasdaq-100, the ETF world has branched out significantly in the past few years. Funds now exist that target a variety of exciting industries or help investors to play on trends more easily.
Take for example some of the recent launches in the biotech world, as funds now exist that only hold companies on the cusp of medical breakthroughs, or products that invest in companies that have recently made their initial public offering.
While investors can definitely buy up risky biotech stocks or recent IPOs, the risks in both are obviously very high. But with ETFs for each, you can buy the entire trend in the space and not concern yourself with a dud or two as the overall positive trend should help to carry the space to gains.
So while funds definitely exist that give you broad market exposure, there is plenty of segmentation nowadays too. Almost any trend you are thinking of — from cyber security and social media to fracking and business development companies — can be targeted with an ETF; gone are the days of major S&P sector choices and that is it.
2) Leveraged ETFs Are a ‘Scam’. What’s Wrong with These Products?
Investors don’t seem to understand how leveraged ETFs work despite issuers bending over backwards to provide extensive information on the topic. And while many ETF names are a bit on the long side, the key to all leveraged ETFs is usually right there in the name.
This is of course referring to the fact that nearly all of the leveraged and inverse ETFs out on the market have ‘daily’ in their names and rebalance on a daily basis. In other words, the exposure resets at the end of each trading day, making each session independent of the following day. These products are designed to be used for a single trading day and are really only intended for day traders and other extremely short-term trades.
Actual investors (as opposed to traders) should stay far away from these products as longer term performance figures will almost certainly deviate from what you might expect them to be. But that doesn’t make them a ‘scam’; it just means that they are being used for a longer time frame than what the issuer intended.
Buying and holding leveraged ETFs is sort of like using daily contacts, but deciding to keep the lenses in for months at a time instead. Sure you can get away with an extra day or two, but they said right up front that these are supposed to be used for a single day only.
Knowing that, why would you take the risk of using them for long time periods? You wouldn’t do that for your eyes and you certainly shouldn’t do it for your portfolio either. So always keep in mind the time frame of leveraged ETFs before using them in your investing strategy.
3) I Have Stocks. What Do I Need ETFs For?
Stocks are great when you have a favorite company in a top industry. But sometimes, you either don’t know which company is an appropriate target in a sector, or you have spotted a trend and you cannot really access it with traditional stock investments.
This is where ETFs really shine as they can provide excellent exposure to a growing trend, or they can help investors get into areas that would otherwise be off-limits. Two of the most recent innovations in the ETF world are great examples of this trend: China A-Shares and hedging strategies.
The China A-Shares market is a special class of Chinese securities that are pretty much closed off to Western investors. However, if you have a qualified foreign institutional investor designation, you can tap into the space. Since this is only available to institutions, regular retail investors like you and me are out of luck if we want exposure, save for a series of ETFs that have been launched recently in the space.
These have proven to be winners in recent trading too as they have crushed broad markets both here in the U.S. and in China as well. In fact, two of the ETFs targeting the space were actually the best performing equity ETFs for Q1, bar none, as both saw gains in excess of 30% for the quarter.
Hedging strategies have also become extremely important as the dollar has soared and more worries are coming over future interest rate hikes. Now investors can buy German stocks without worrying about the fluctuations of the euro, Japanese stocks without concerning themselves with trends in the yen, or high yield bonds without worrying about duration risk.
All of these strategies have either paid off handsomely over the past few months or could definitely come into focus later this year. And all of them would be pretty much impossible for retail investors to implement on their own without recent ETF innovations.
So clearly there is a place for ETFs in a stock investor’s portfolio as they can help you tap into important trends that only institutions can access. Now you aren’t limited to just a few stocks as literally the whole world is at your fingertips with the advent of ETFs.