Are Advisors Making Smart ETF Choices?

Exchange-traded funds are taking the investment world by storm. But despite an influx of new products, there are some funds that are more popular than others amongst those many rely on for advice -- financial advisors. Should we follow their lead and buy these funds?

Taking stock
Morningstar data compiled by Investment News shows that of the top 10 most-researched ETFs by financial advisors last year, four focused on broad sections of the stock market:

If nothing else, I'm glad to see that advisors are consistently looking at broad-market, well-diversified ETFs. Funds like the iShares S&P 500 Index or the SPDR (NYSE:SPY) can serve as the heart of an investor's domestic ETF portfolio.

I also think highly of the three foreign ETFs presented here: Any of them would be a good choice for a diversified investor. However, I do view the sudden advisor interest in these funds with some suspicion. Because foreign markets and emerging markets in particular were such stellar performers last year, I don't doubt that some of this interest may be simple performance-chasing. It's only natural for advisors to be lured by outsized recent gains -- after all, emerging markets were up nearly 75% last year! 

I still think emerging markets have excellent long-term growth prospects, and every investor should have at least some exposure to this corner of the market. However, there are some near-term red flags indicating that foreign markets may take a breather, so I would temper expectations for now. If you invest in foreign ETFs, continue to allocate money to this sector, but don't expect a repeat of 2009's hot performance.

Bonds have their day
Of course, in light of the latest market downturn, investor fear and uncertainty has been a boon for bonds and the funds that invest in them. That's why it's not surprising to see three bond funds on 2009's ETF hit list:

Again, I don't have any problem with these three funds -- they're low-cost avenues for gaining exposure to a broad section of the bond market. That's just what investors should be doing.

It is interesting to note that a TIPS ETF topped the research list last year. Given the groundswell of concerns about future inflation, it's not surprising that more and more folks are employing TIPS as an inflation hedge. While I still think that troublesome inflation is a distant threat, it's probably not a bad idea to start protecting against inflation now. Having a decent TIPS allocation is even more important for investors who are in or near retirement. Because they should have a good portion of their portfolios in bonds, preserving purchasing power is vitally important -- which TIPS can help accomplish.

I do think, though, that investors who see bond funds as perfectly safe may be in for a disappointment. With interest rates at historic lows, I think the bond market's run is pretty close to being done. I see rates rising, likely sometime later this year, which will put pressure on the bond market. If you're a long-term investor, that doesn't mean that you necessarily need to change your bond allocation -- just don't expect huge returns.

Chasing commodities
Given that gold has been the top-performing asset over the past decade, it's inevitable that commodities would get a lot of attention:

Here, I think advisors are flat-out chasing performance. I'm guessing most of the interest in commodities is because of their recent gains. It's hard to ignore trends when those trends are making a lot of money, but I think that's what investors and advisors need to do here. 

Although many disagree, I don't think that commodities are an essential part of a well-diversified portfolio. Over the very long run, stocks have done a better job of preserving and growing wealth. Furthermore, one of commodities'  much-touted benefits -- inverse correlation with stocks and bonds -- has declined in recent years, thanks in part to increased investor attention. Investors who jump on board with significant gold and commodities exposure now may end up hurting themselves in the long run. I think commodities should make up at most a very small portion of your portfolio -- and you should realize that much of the party is likely already over for this asset class. 

The right move now
In your own portfolio, make sure you keep your eyes on your long-term asset allocation and don't feel the need to buy ETFs that may be popular at the moment. It may be tempting, but in the end, you're more likely to get burned by those "hot" funds than you are to make millions. 

Do you disagree? Feel free to let me have it by leaving a comment below.