How Investors Can Harness the Power of ETFs

Learn how Exchange-Traded Funds can lower your costs, boost returns.

Jan. 23, 2014 -- Investors who wisely seek to avoid active management — where investors or the managers of mutual funds they own choose stocks for portfolios — have long turned to index funds because they remove this discretion and the risk it brings. These funds track indexes, such as the S&P 500.

This form of investing is known as passive management, as opposed to the active management of picking stocks or hiring a fund manager to do so, as with mutual funds.

Over the past two decades, investors have flocked to index funds as a way to reduce investment costs (mutual fund managers must be paid) and capture the gains of the market instead of trying to beat it. After they were introduced in the 1970s, index funds at first slowly gained followers, but their popularity has grown significantly over the past 20 years.Yet, more recently, another form of passive management has been capturing investors' fancy: exchange-traded funds (ETFs). Like index funds, ETFs are funds whose performance is linked to certain segments or indexes of the overall market. These investments were first offered in the 1990s.

This relatively new investment vehicle is an excellent way to access the stock market without the risks of buying individual stocks. Women – or men -- seeking to become financially empowered should consider ETFs as a highly beneficial way to avoid the risks involved in active portfolio management.

ETFs have some key advantages over index funds. Compared with index funds, ETFs are:

• Less expensive. Initial fees are lower, and so are expense ratios (the perennial fees charged by investment companies). However investors should be aware that there is a wide range of expense ratios charged by ETF products, so be sure to compare these before buying.

• More tax-efficient, so you end up paying Uncle Sam less on capital gains.

• More liquid. With index funds, you must wait until the end of the trading day to sell shares. But because ETFs are traded on exchanges, as their name indicates, you can buy or sell at any time during the trading day.

• More targeted. Because a myriad of ETFs are available, when used correctly they can enable greater portfolio diversification, allowing you to spread your holdings over a broader array of companies of different sizes and industries to protect against risk.

• More flexible. Index funds tend to reinvest dividends automatically, but when you own ETFs, you get a check, so you can invest this money as you see fit. This way, it's easier to keep your portfolio in balance. For example, if you own an S&P 500 ETF, which consists of large companies, and this index has been doing quite well for a long period, you might buy ETFs composed of a different asset class, such as smaller companies, to keep your asset allocation from getting out of whack. Automatic reinvestment of dividends could grow your investment in large companies to the point where your total investment in them exceeds your original asset allocation, increasing your risk from a severe downturn in the performance of those companies.

You can buy ETFs wherever stocks are sold. As with stocks, you'll pay more for them through a traditional brokerage account and less through an online brokerage. Different providers market their ETF shares by different names. BlackRock calls them iShares; State Street Corp. calls theirs SPDRs (pronounced "spiders") and Vanguard Group, Vanguard 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.

So if you're an index-fund investor — or, to your peril, someone who invests in actively managed mutual funds or, even more perilous, picks their own stocks — consider the benefits of carefully chosen ETFs. There are good reasons why millions of investors have been buying them in recent years.

This work is the opinion of the author and not that of ABC News.

Laura Mattia is a partner with Baron Financial Group, and a fee-only financial advisor. She's a Certified Financial Planner professional (CFP®), a Chartered Retirement Plan Specialist (CRPS®) and a Certified Divorce Planner (CDFA™) and holds an M.B.A. in accounting/finance. Her Internet radio show is Financially Empowering Women™ with Laura Mattia. A professor at the Rutgers University Business School, Mattia is completing a Ph.D. in financial planning from Texas Tech University; her dissertation is on how to help women plan for retirement.