Over the past decade, exchange-traded funds have moved out of an obscure corner of the market to become one of the fastest-growing investment products around. As ETFs have grown in popularity, countless new versions of these funds have been rolled out, slicing and dicing the market into ever-smaller segments. But while investors can now focus on very narrow parts of the market, many of these new funds face challenges when it comes to trading.
Spreading the wealth
A recent Wall Street Journal article highlighted some difficulties many of the new ETFs are encountering. During times of high market volatility like the past six weeks, investors have faced wide trading spreads on many of these funds. Since ETFs trade on exchanges like stocks, they are often subject to a bid-ask spread, or the difference between what buyers are willing to pay for the fund and what sellers are willing to sell for.
This problem has been especially pronounced among the small, less widely traded ETFs. For example, the HealthShares Infectious Diseases ETF, with only $3 million in net assets, had an average spread of 1.6% of its market price during the second quarter of the year. In contrast, large, more actively traded funds such as the iShares S&P 500 ETF (NYSE: IVV ) and the iShares MSCI EAFE ETF (NYSE: EFA ) had average spreads of only 0.02% or less during July and August.
The problem with wide bid-ask spreads is that they can cut into your investment returns. In effect, wide spreads are an additional cost that most ETF investors did not expect to pay. While some trading costs should always be expected, there is little reason for investors to put up with excessively wide spreads on their funds. ETFs were designed to be a cheaper way to gain exposure to the market, but the additional costs can chip away at ETFs' much-vaunted cost advantage over traditional mutual funds.
Unfortunately, the problem is unlikely to go away any time soon. Most of the new ETFs hitting the market in the coming months are narrowly focused funds that will likely face thin trading activity. As a result, it is likely that these small-niche ETFs will also face wide trading spreads, especially if market volatility remains high.
Looking at the big picture
However, the solution to this problem is fairly easy for most investors: Stay away from niche-market ETFs. So many funds are simply too narrowly focused for the average investor, and most folks would do well to avoid them. There is no reason investors need an ETF that invests exclusively in only one highly volatile sector of the market, such as cancer-related health-care companies, or metals and mining firms. The same goes for funds that invest in just one country, such as China or India. On their own, most of these ETFs are not nearly diversified enough for investors, and are typically more volatile than broad market funds. And unfortunately, most investors don't actually use these types of funds strategically as a part of a large, diversified portfolio, they merely add them in as a "boost" to try to juice their returns.
Additionally, these niche market funds are almost always more expensive than funds that focus on the broad market. Why pay more expenses and trading costs to own several narrow ETFs when you can get cheap exposure to a wide array of stocks by owning a more diversified fund like a Spider (AMEX: SPY ) or the Vanguard Total Stock Market ETF (AMEX: VTI ) ? You are far less likely to have to worry about abnormal trading spreads on these types of funds.
So while some of these new narrow-market ETFs initially look like a shiny new toy you just have to have, you probably don't need any of them. Stay invested in broad funds, and let someone else pay the trading costs for niche funds. In the end, you'll be glad you did.