The Popular Investment No One Understands

There have been a lot of financial losers in recent years -- underwater homeowners, debt-strapped municipalities, and even actively managed mutual funds. Investors who expected their managers to protect them during the financial crisis were sorely surprised, as the majority of active managers were caught flatfooted by the market decline. As equity funds dropped in value, many investors headed for the exits.

This disappointing experience with actively managed funds has helped contribute to the rising popularity of index-based products, including exchange-traded funds. This month, total assets held in ETFs reached the $1 trillion mark, according to investment firm BlackRock. But even as these investment products reach new heights of popularity among investors, it appears that a sizable number of Americans are missing out on the ETF revolution, and more surprisingly, they don't even understand exactly what they are.

In the dark
A recent study by research firm Mintel Comperemedia found that 64% of investors simply don't understand exchange-traded funds. According to the survey, nearly two-thirds of respondents either don't know anything about ETFs or don't understand how they work. But that's not all. An additional 15% of investors said that they don't own ETFs because they are "too complicated." If the results of this survey are even halfway representative of the larger investing public's attitude toward exchange-traded funds, clearly there is a huge knowledge gap.

A spokesperson at Mintel Comperemedia speculated that perhaps investors are less familiar with ETFs because they are typically not available in company-sponsored retirement plans and because financial advisors are not as well-acquainted with these investments. The study revealed that those investors who do own ETFs typically look to their advisors for ETF ideas more often than for other investment ideas. I think these are both pretty plausible ideas and probably are a large part of the problem here.

Finding the easy button
It's pretty shocking that 15% of surveyed investors view exchange-traded funds as too complicated. Put simply, ETFs are funds that track a certain market index and are designed to offer roughly the same return as that index. They are pretty much the same as your run-of-the-mill index fund, with the exception being that they can trade throughout the day just like stocks can, whereas mutual funds only trade at the end of the day based on their net asset value (NAV). They can also be sold short like shares of a stock. In my opinion, the best feature of ETFs is that they are almost universally cheaper than actively managed mutual funds, so you can invest without forking over oodles of your hard-earned cash to fund management.

The fact that more financial advisors aren't aware of or aren't recommending ETFs to their clients perhaps isn't that surprising. Given that the traditional advisor model relies on recommending load-carrying mutual funds that provide the advisor with a commission for directing clients into the fund, it's easy to see why ETFs are less popular. There's no direct financial incentive for the advisor to recommend ETFs. That's why I recommend that anyone thinking about engaging the services of a financial advisor should stick to fee-only professionals. That way, you can be certain that you are getting unbiased advice that isn't influenced by how much an advisor is being paid by a fund shop.

The right mix
If you're looking for an easy and inexpensive way to get exposure to wide swaths of the market, there simply is no better way to accomplish that than with exchange-traded funds. You can set up a nearly completely diversified portfolio with just a few ETFs. Here's a simplified sample asset allocation scheme for an investor with more than 10 years left to retirement:

Exchange-Traded Fund

Allocation

Expense Ratio

Vanguard Total Stock Market ETF (NYSE: VTI  )

50%

0.07%

iShares Russell 2000 Index ETF (NYSE: IWM  )

15%

0.20%

iShares MSCI EAFE Index (NYSE: EFA  )

15%

0.35%

Vanguard Emerging Markets Stock ETF (NYSE: VWO  )

10%

0.27%

Vanguard Total Bond Market ETF (NYSE: BND  )

10%

0.12%

The two key things to remember when it comes to ETF investing are to buy cheap and buy broad. Buy the cheapest fund that will get the job done. You're not paying for any manager expertise here, so it doesn't make sense to pay more for ETFs. Also, try to stay away from narrowly focused funds that invest in a single country or sector. Most investors who buy funds like these don't have a strategic reason for owning them but are simply drawn to the strong returns these funds can post from time to time. Broader funds that invest across sectors and market areas are a better bet for most investors. And finally, remember that ETFs should be used as long-term investments. Just because you can trade them throughout the day doesn't mean you need to burn up your brokerage account with frequent trades.

If you have already discovered how ETFs can work in your portfolio, congratulations -- you're one step ahead of the majority of investors out there. If you haven't, consider taking a few minutes to learn more about what is likely the most influential and popular investment of the past decade.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. BlackRock is a Motley Fool Inside Value recommendation. Motley Fool Alpha has opened a short position on iShares Russell 2000 Index. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 31, 2010, at 5:25 PM, ChrisFs wrote:

    Nice article. However there are wrinkles beyond that.

    Long term investors should avoid leveraged ETFs, those that offer 2-3x the return of an index. Due to the way they are structured, for periods beyond 3 months, they will lag significantly behind the index and in a number of cases, lose money even if the index is positive.

    Some commodity ETFs also perform poorly over a long term, since they invest in futures and must consistently but new futures as the current ones expire. This not only adds trading costs, but also means it's harder to profit from any long term shifts in the commodity prices.

  • Report this Comment On January 02, 2011, at 11:49 AM, RHinCT wrote:

    You make the case for ETFs against managed mutual funds and load carrying mutual funds. You equate ETFs to index funds. So the choice really comes down to ETF vs index fund, and that question you do not address beyond the issue of during-the-day trading. How about comparing some ETFs and their equivalent index funds on the basis of cost? You say the real advantage of ETFs is that they are cheaper than something that is not equivalent. SO ARE INDEX FUNDS.

    Maybe NEXT time you will compare them to something comparable. Of course the answer won't be as obvious then.

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