It's no secret that exchange-traded funds are quickly becoming the investment vehicle of choice for millions of investors. Thanks to their low costs, generally greater tax efficiency, and trading flexibility, ETFs have been one of the few clear winners in the investment game in recent years. But that doesn't mean investors can't misuse ETFs from time to time. So how does the current landscape look in ETF land?
Show me the money
According to State Street Global Advisors' midyear SPDR outlook, exchange-traded funds saw net inflows of $56.3 billion in the first six months of 2011, an increase of more than 50% from the same period in 2010. So far this year, the biggest winners, asset-wise, have been fixed-income ETFs, with inflows of $16.3 billion, followed by developed international funds with $12.6 billion in new inflows, and dividend funds with $6.4 billion. Some of the biggest losers this year have been emerging-markets, domestic small-cap, and commodity ETFs, which have seen net outflows of $3.7 billion, $2.2 billion, and $2.1 billion, respectively.
Given the general level of fear and uncertainty in the market right now, it's not terribly surprising to see fixed-income funds still raking in the money, but it is disappointing. While all investors should have some fixed-income exposure, and folks in retirement should have at least half of their assets in bonds, long-term investors need to get back in the game and up their exposure to the stock market. I think we're going to be in for a difficult few months in the equity markets, but bonds simply aren't yielding enough to be attractive long-term investments right now. Having some exposure to broad bond ETFs like Vanguard Total Bond Market ETF (NYSE: BND ) or iShares Barclays Aggregate Bond ETF (NYSE: AGG ) is a good idea, but if you've got a decade or more left to go before you retire, you probably shouldn't have much more than 10% to 15% of your portfolio in bonds.
On the domestic stock side, I am glad to see investors seeking refuge in dividend-paying large-cap stocks, a relatively undervalued segment of the market. Small caps have had an incredible run in the past decade, but given that we're past the initial stages of the recovery, when smaller companies tend to outperform, and given the valuation gulf between small- and large-cap stocks, it's hard to argue that larger names aren't the better deal now. Of course, some of this newfound love for larger fare may be a result of the fact that large-cap stocks have generally outperformed small caps year to date, so we could just be seeing the effects of performance chasing. But the trend has some meat to it.
There aren't a whole lot of areas of the stock market that I'm really enthusiastic about, but dividend-paying blue chips are one of them. Given how fast and furiously stocks have fallen in the past few weeks, it looks like the market is pricing in some pretty dire times ahead. While no sector of the market will escape unharmed, financially stable blue chips that have a history of paying healthy dividends are some of the best-positioned to weather any potential storms. So make sure you've got some exposure here. If you're not an individual stock picker, a low-cost ETF like Vanguard Dividend Appreciation (NYSE: VIG ) or SPDR S&P Dividend ETF (NYSE: SDY ) can quickly and cheaply fill that role in your portfolio.
It's also not a total surprise that investors have been shedding exposure to emerging markets in recent weeks, as this area has pulled back. The iShares Emerging Markets ETF (NYSE: EEM ) is down about 3.6% on the year, while the iShares MSCI EAFE ETF (NYSE: EFA ) , which measures performance of developed foreign markets, is down only 0.6%. So, again, the new flows into and out of ETFs that we've been seeing may simply be a reflection of investors reacting after the fact to recent performance trends.
In the case of foreign stocks, I think investors should probably be somewhat wary in the short term. The debt crisis in Europe has not been solved, and yields on Italian bonds just reached a euro-era record high versus the yields on similar German bonds. This indicates an increasing lack of confidence in the ability of officials to resolve the suffocating debt loads weighing not just on headline-maker Greece, but also on bigger fish like Spain and Italy.
I wouldn't necessarily cut back on developed-market exposure right now, but I might think about deploying any new money to areas outside the eurozone. I think things will be rough for just about all areas of the globe in the near term, but right now I'm a bit worried about how things will shake out in euro-land. However, potential fallout from a slowdown in China means risk in emerging markets is heightened as well, so for fund investors, I'd recommend taking a balanced approach here and investing in very broad market ETFs, such as the Vanguard Total International Stock Index ETF (NYSE: VXUS ) , which fishes in both developed and emerging markets.
Ultimately, there's a lot of risk out there, and investors should be prepared for more volatility and downside surprises in the next few months. But exchange-traded funds can still be an important part of anyone's portfolio, if you buy wisely given current market trends and buy for the long run.
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