Use Niche ETFs with Care

From their humble beginnings, exchange traded funds were originally engineered as a simple passive investment tools that tracked an underlying benchmark index. As the industry expanded and ETFs proliferated, fund products are becoming more complex and investors should understand the evolving nature of the investments.

The ETF investment started out simple enough but it has grown more complex, offering enhanced returns, such as through leveraged products, and managing volatility, reports Paul Sullivan for the New York Times.

As with all investments, these new products require added education so that investors know what they are getting themselves into.

“You’ve got to know what you’re buying,” Greg Peterson, director of research at Ballentine Partners, said in the article. “The ETF will do what it says it will do. But people don’t know what to expect.”

Additionally, investors should know that more complex ETF options may charge higher fees, especially those that cover niche areas of the markets where it will be costlier to acquire securities or those that fall under actively managed strategies, compared to traditional beta-indexed products.

“If you hold it for five years, that cheaper ETF may make more sense,” Jim Ross, a senior managing director at State Street Global Advisors, said in the article. “But it’s like going into the drugstore: the generics are always cheaper, but they may not be better.”

Recently, more fund sponsors have been adopting enhanced, “smart” or “intelligent” indexing methodologies that customize the underlying index. While the ETFs are passive in nature, the underlying index would follow strategies similar to actively managed styles.

“ETFs have been so successful that people have engineered ETFs that don’t follow the same functions as the original ones,” Peterson added. “Those original ETFs were broad, stock-based index-traded funds that were really efficient ways to gain core exposure to core markets.”

The changes are not bad, but the investor should take the time to understand an investment’s objective before diving in.

For  more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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