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As investors look to get their portfolios and their dreams of retirement back on track after the recent market meltdown, new ideas and new ways of investing are gaining in popularity. Burned by the "conventional" Wall Street wisdom, investors are shuffling their portfolios, firing their advisors, and looking for different investment vehicles. And while many stock fund managers have been at a loss to attract new money in the current environment, there is one sector that hasn't gotten the message that we're still in a slow-growth economy.
Growing by leaps and bounds
If you want to invest in the fastest-growing area of the market, look no further than exchange-traded funds. While these funds certainly aren't market newcomers, the number of offerings and total assets in this sector have far outpaced growth in any other corner of the investment world. In fact, according to investment manager BlackRock (NYSE: BLK ) , worldwide ETF assets reached $1 trillion at the end of 2009. Assets in the U.S. were about $700 billion, while foreign ETF assets, mostly in Europe, accounted for the remaining $300 billion.
For a lot of folks, the fact that exchange-traded funds have grown so quickly in popularity isn't all that surprising. ETFs offer several advantages over traditional mutual funds. One of the biggest pluses is their lower cost. According to Morningstar data, the average mutual fund has a net expense ratio of 1.33%, while the average ETF clocks in with a mere 0.56% price tag. Additionally, ETFs have more flexibility, since they can be traded throughout the day, instead of just at market's close, like traditional mutual funds. Lastly, ETFs are typically thought to be more tax efficient than actively managed funds, thanks to less frequent trading and limited realization of capital gains.
Putting traditional funds on notice
If you've got a hankering to get in on this fastest-growing investment vehicle, there are three rules of thumb you should follow when making your investment choices. First, stick with low-cost offerings. There is no reason to pay much more than 0.30% to 0.40% in expenses for an ETF. For example, the SPDR S&P 500 ETF (NYSE: SPY ) will cost you just 0.09%. You can definitely find some funds that charge as much as 1.00%, but those aren't funds you want to own.
Secondly, think big and broad when investing in ETFs. Look for well-diversified, broad-market funds, not funds that focus on one narrow, specific sector of the market. The Vanguard Total Stock Market ETF (NYSE: VTI ) , which seeks to track performance of all NYSE- and Nasdaq-traded stocks, is a good choice. Bond investors should consider the iShares Barclays Aggregate Bond ETF (NYSE: AGG ) , which tracks the entire U.S. investment-grade bond market. Investors looking for exposure to foreign emerging markets might want to look at the Vanguard Emerging Markets ETF (NYSE: VWO ) , which sports a 0.27% expense ratio, lower than almost any other foreign-focused ETF.
Lastly, take a long-term buy-and-hold approach to ETF investing. Just because these funds have the ability to be traded throughout the day doesn't mean you should do that on a regular basis. Don't look at ETFs as short-term profit-making opportunities, but rather as long-run asset allocation vehicles. Getting involved in day trading ETFs could eat away at any cost savings you might otherwise reap, thanks to the commissions you'll incur. Investors with a long-term time horizon should obviously invest for the long haul, and that includes ETF investing.
A word of caution
Of course, we all know that the Wall Street hot shots can't leave well enough alone, and once they see an area of the market that's making money, they'll quickly flood it with new products. Not content with "boring" broad-based index-like ETFs, money managers have quickly introduced sector-based, tactical, and even actively managed ETFs.
Unfortunately, not only are these funds more risky, they are also usually much more expensive. For example, the Dent Tactical ETF (NYSE: DENT ) , an actively managed ETF, currently levies a 1.56% charge for the price of admission. That's higher than the average actively managed mutual fund!
Likewise, investors can buy inverse ETFs, leveraged ETFs, and even inverse leveraged funds. If you really want to crank up the risk, the Direxion Daily China Bull 3X Shares ETF (NYSE: CZM) offers 300% of the daily return of an index that tracks the Chinese stock market. That's just crazy, and more akin to gambling than investing! Remember, just because there are shiny, new ETFs on the market doesn't mean you need them. Most investors are better off with plain-vanilla, broad-market exchange-traded funds.
ETFs may have a ways to go to catch up with actively managed mutual funds, but they are gaining ground every day. This area of the market is likely to receive a lot of investor attention and money in the coming years. There are plenty of ETF opportunities out there; make sure you invest wisely and with a long-term focus in mind.
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