How Investors Can Harness the Power of ETFs

Look for quality ETFs that fit into your investment strategy. Consider how an ETF is constructed (the companies it holds or tracks) and how long it has been around. Be wary of new, unproven ETFs and those that focus on a small, unique universe of stocks. Also, look for ETFs that are frequently traded; this lowers the costs of buying and selling shares and ensures that you will be able to sell when you want. Avoid the new ETFs that have recently come on the market until they have built up enough market awareness to become sufficiently liquid. Using limit orders can help avoid large premium or discount executions due to thinly traded ETFs.

ETFs are by no means limited to stocks. They are available for a wide variety of asset classes, including alternative investments, so named because they are alternatives to traditional investments of stocks and bonds. Alternative investments include commodities, such as coal, oil, real estate and precious metals.

Holding a small amount of alternative investments can be a good way to add a tincture of risk-protective diversification to your total portfolio because their value tends to move in different directions than stocks or bonds (but not always).

Purchasing commodities directly, outside of a fund, is extremely expensive. ETFs are a cheaper, less stressful way to access this asset class. You can get a highly diversified bundle of commodities — everything from gold to livestock — in a single ETF that may own various types of commodities that behave differently, thus averaging out risk from any single commodity. Here again, however, you need to understand what you are buying. One popular related product is a commodity ETN (exchange traded note) which, though it can be cost efficient, is actually an unsecured debt security. So it creates another risk that you should be aware of -- the risk of default by the issuer of the debt. Another way to gain exposure to commodities is through ETFs that hold the stocks of commodity-intensive companies as an alternative means of getting exposure to natural resources. The various categories of ETFs available include bond ETFs. In general I don't recommend bond funds because they expose investors to the potential risk of rising interest rates — especially these days.

Interest rates have been historically low for more than 30 years, and are now at or near all-time lows. So there's nowhere for them to go but up, and a rise is widely anticipated. As interest rates go up, bond values go down. Owning bonds directly enables you to minimize your holdings in short-term bonds, reducing your exposure to rising interest rates since you can hold them until maturity. Owning bond funds tends to expose investors more because the underlying bonds are not held until maturity.

However, there's one exception: target-date bond ETFs. This new product, introduced by several firms in recent months, combines the benefits of bonds and affords control of portfolio maturity, yield and credit quality — all with the diversification, liquidity and convenience of ETFs. Because they function basically like individual bonds, they can be used to manage interest-rate risk. By contrast, standard bond ETFs don't break out maturity periods. Bonds held within standard ETFs continually roll over, an arrangement that denies investors sufficient latitude for controlling risk.

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