The continued growth of ETFs isn’t going to stop anytime soon. If your 401k doesn’t offer them as an investment option, just wait. It will soon. As the low-cost equivalent to most mutual funds, ETFs are becoming the go to investment of choice for anyone not willing or interested in stock picking and owning individual bonds. But is it a good thing.
One of the benefits everyone, myself included, touts about ETFs is how easy it is to buy and sell them. The soonest a mutual fund share transaction goes through is at the end of the business day, if you’re lucky. With ETFs you can buy and sell them in microseconds and its done. Now anyone can be a trader for a day and the growing number of exotic, “smart” beta, and specialized ETFs just makes it easier. There in lies the dilemma.
Warning: Not For The Emotionally Inclined
The one thing we learned from the ’90s market boom and the recent crash, people invest on emotion. We throw out the rules and do the exact opposite of what we should. Buy when the markets screaming higher, because it can only go up, right? And then sell as it plummets because it can only go down. Last time I checked, the sky has never fallen even if Chicken Little says different. The ability to buy and sell at the push of a button is beyond convenient.
Now with ETFs we have the power to make emotionally charged investing decisions on a dime. Not good for someone who freaks out because the market went down 2%. Add up the millions of people who can’t emotional disconnect from their money. It won’t be a pretty sight. There is such a thing as too much control. Especially in the hands of the wrong investor.
Warning: Specialized ETFs Aren’t Special
The proliferation of ETFs has opened up new markets for the average investor and has done so without a warning a label. Outside of the typical index ETFs, there is commodity, currency, real estate, inverse, 2x leveraged, 3x leveraged, energy, bond, actively managed, city specific, country specific, and the list goes on. Having so many options may sound great but it comes with a hitch. It only adds to the confusion of investing.
Here’s a few things to keep in mind when investing in Specialized ETFs:
- Have a solid, broad base of stock and bond ETFs before investing in any specialized ETFs.
- It must pass the ETF name test, meaning you understand the funds objectives just by its name alone. If you can tell me what a ProShares Short VIX Short-Term Fut ETF does, you have my permission to invest in it!
- The more exotic or specialized the ETF, the more risky and less diversified it becomes.
- Just because it’s an ETF doesn’t make it diversified. The Vanguard Energy ETF (VDE) has two stocks that make up about 36% of the fund. The SPDR Gold Trust (GLD) is 100% invested in gold bullion.
While the new and ever-growing ETF industry has been viewed as a good thing for investors, there are drawbacks. It’s certainly not for everyone and brings with it added confusion. For the new investors I’d recommend sticking to the basics, good solid index funds, before marching into any specialized ETFs and leave your emotions at the door.