May 20, 2012. Samuel Valero
Exchange-traded funds (ETFs) have seen an almost incredible increase in their total market capitalization in recent years. More and more ETFs have been created, tracking everything from stock indices to commodities.
By 2010, they have become the most actively traded product on international stock exchanges. Naturally, they are an important part of every large institutional portfolio. But, are they really a good investment?
One of their perceived strengths is their passive approach to investing compared to the typically active management of mutual funds. Many publications over the years have evaluated the performance of mutual funds, and found them wanting more often than not. As many mutual fund managers manifestly do not beat or even track their benchmark, passive index tracking has become well-established and certainly advantageous.
ETFs also allow an individual investor to achieve a diversification which is almost impossible to realize by any other means. Due to the transparency typical for ETFs -because all securities and their weights in the fund are clearly stated now and for the future- an investor knows exactly what his money will be used for. Additionally, it is often impossible due to market restrictions to directly invest in the index represented by the ETF – a clear example would be a natural gas ETF.
Their flexibility is also a superior advantage. Exchange-traded funds are traded on a stock exchange like stocks. Unlike mutual funds, their price is determined by supply and demand, and intra day trading is perfectly possible. Also, hedging strategies which are essential for any large portfolio can be realized with ETFs similarly as with individual stocks, especially buying these instruments on margin or selling them short.
The advantages shown above are a major reason for the unbroken popularity of ETFs. But still, are they a good investment? In general: yes, but they are always only as good as their underlying index. More care is required with recent ETF innovations which track complicated indices or commodities like a copper ETF, but overall the positive answer remains true.
Updated May 20, 2012. Published July 12, 2011. Samuel Valero
