As terrific as exchange-traded funds are, they have their limits. Investors who are tempted to rely solely on this type of investment product need to know the pitfalls of that approach, and to steer clear of a new type of product that encourages it.
Now, I have been a big fan of ETFs since their inception. They clearly offer do-it-yourself investors a chance to be better portfolio managers, and offer professional investors a chance to manage pools of capital with more efficiency. As these investment tools catch on, expect more innovation from the ETF providers, which will result in more opportunities for investors to reach their financial goals. I have unyielding faith in the benefits of ETFs; I use some in my practice and own some personally.
But ETFs are not a panacea.
In the last couple of years, a lot of new ETFs have been created, some innovative and some not. There has also been a proliferation of products that cater to ETF investors such as open-end funds comprised of ETFs, all-ETF portfolios offered by both the sell side and the buy side, and newsletters devoted to ETFs. Investors must choose carefully; to help them do so, I'd like to point out some ETF blind spots and review a new set of products, managed all-ETF portfolios, that sound great but actually just compound the disadvantages of ETF investing.
Know ETFs' Limitations
ETFs are just one tool available to investors. Others include stocks, closed-end funds, OEFs, structured products and unit investment trusts. As much as I believe ETFs help empower investors to get better results, they will not always be the best possible tool to capture specific parts of the market.
I mean that geographically in particular. While there are several ETFs that give investors broad exposure to regions such as China, Austria and Canada, there are some gaps. For example, Ireland offers a healthy and growing economy with a pro-business government, and is one of the wealthiest countries in Europe per capita. Yet there is no ETF that U.S. investors can easily access. There is a CEF,
The New Ireland Fund
, and there are several
-listed ADRs. I capture this market for clients with one of the ADRs.
Norway is another important investment destination because it is a huge oil producer. But the only way to gain exposure to this country's economy in the public markets is through a very few ADRs. There are no ETFs, CEFs or even OEFs I can find that isolate Norway.
Investing in Brazil highlights another wrinkle in using ETFs for foreign exposure: ETF blinders. Would-be investors in Brazil have an ETF, CEF and several ADRs available to them. I can appreciate that Brazilian common stock may not be right for many people. For them, there are a couple of alternatives: an ETF,
, and a CEF,
The Brazil Fund
The iShares Brazil has about 15 times the average daily volume of The Brazil Fund, yet The Brazil Fund has had better returns for one-, two- and five-year periods, has a slightly higher dividend yield and trades at a discount to net asset value. The Brazil Fund has a track record of better success than iShares Brazil (I realize this is backward-looking) but the ETF-only crowd would miss The Brazil Fund. Even if an investor still chose iShares Brazil, expanding the research process to include other types of products would lead to a more informed choice.
Managed ETF Products
Recently, several brokerage firms and banks have rolled out products that offer managed all-ETF portfolios to clients. I studied two,
Amerivest program and the
ETF Portfolio Builder, and found some significant disadvantages to them over just investing in ETFs outright.
In general, this group of products are computer-generated allocations of specific ETFs that attempt to capture a diversified portfolio. For most, investors complete a questionnaire that allows the program to establish an ETF portfolio based on risk tolerance and time horizon. The result will be a group of seven to 10 broad-based ETFs ranging from
iShares S&P 500
iShares Russell 2000
. But a computer-generated, automatically rebalanced portfolio that can assess only past performance of the ETFs in its stable of choices gives investors no forward-looking analysis, and that's a major negative.
What's more important, where the component ETFs have been or where they are going? Consider this simple analysis: Several strategists have said the next few years will offer below-average returns for U.S. equity markets. An investor who buys into this line of thinking may want to overweight dividends. That type of simple forward look hardly requires a CFA designation, yet a computer-run product can't offer even that much analysis.
The concept of getting help investing in ETFs along the lines of a managed portfolio will appeal to plenty of people who are not comfortable or confident enough to do it themselves but who don't have enough capital to retain an account manager. But because these products offer little to no forward-looking analysis, they amount to a disservice, as small accounts aren't entitled to more than a computerized rebalancing of a backward-looking portfolio.
Another drawback is that many of the products don't make use of all of the ETF families or products. Most of the ETFs offered are from iShares, which is not ideal because no single provider can have the best product for every single slice of the market.
Worse, these portfolios use just a narrow spectrum of ETFs from those families, offering only broad-based ETFs such as iShares S&P 500 or
iShares Russell 1000
. By sticking with only the biggest, broadest ETFs, these portfolios deny investors access to a lot of innovative ideas and the chance to add value.
I view these products as top-down portfolios. As a top-down manager, I make decisions about market capitalization, style, volatility, yield, countries and sectors. The current batch of ETF portfolio products for the most part ignores countries, sectors, volatility and yield, and focuses only on market capitalization, style and domestic vs. foreign investments, "foreign" being a much broader focus than selecting exposure to individual nations.
It's worth noting that
allows more customization in its ETF portfolio than other firms. But if you can create your own portfolio with no input from the firm, you don't need to be under the umbrella of the product.
There are many useful applications for ETFs in a diversified portfolio. There is no doubt that the product line will become more useful as competition spurs innovation. But blind over-reliance on any one type of investment is a mistake, and that's definitely true for ETFs.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider The New Ireland Fund to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. At the time of publication, Nusbaum had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;
to send him an email.