BECAUSE THEY CAN BE BOUGHT or sold at any time during the day, offer access either to broad or thin slices of a market at relatively low cost and facilitate hedging strategies, exchange-traded funds have become a favorite of financial advisors. ETFs' overall popularity is obvious. As of June 30, there were about 1,000 of them, with $793 billion in assets, up from 780 handling roughly $600 billion 12 months ago. Barron's recently checked in with five financial advisors who've ranked highly in our surveys over the years and give ETFs a significant role in their portfolios. Here's what they had to report from the front lines.
Zhang Financial, in Portage, Mich., has about $1 billion in assets under management, and ETFs make up a hefty 50% of its holdings. Like other ETF advocates, Zhang, 43, can reel off the well-known benefits of the fundsâ??including their tax advantages. However, he suggests that investors haven't taken full advantage of one important feature: the ability to create limit orders on them to profit from the stock market's recent volatility.
A limit order, which instructs a broker to buy or sell a specific amount of stock at, below or above a preset price, allows clients to cash in on brief trading opportunities in ETFs that Zhang believes are less risky than applying the same strategy to individual stocks. A stock's price can fall for reasons that might be difficult to grasp quickly, or could signal fundamental problems (think BP). But Zhang says a quick intraday drop in the price of a broad basket of stocksâ??creating momentary valueâ??is much more likely to correct itself.
"In a very volatile market like we see today, limit orders to buy and sell make a lot of sense. They let clients take advantage of the ups and downs in the market," says Zhang.
For instance, during the flash crash on May 6, the intraday drop for the Dow Jones Industrial Average was about 10%, but the Vanguard Total Stock Market ETF (VTI) dropped more than 30% from roughly $60 a share. One of Zhang's clients had a limit order to buy $400,000 of the ETF if it dropped to $40, which it did before quickly returning to about $60. Within three days the investor booked a tidy $200,000 profit.
Another broad-based fund Zhang uses for limit orders is the iShares Russell 2000 Value Index (IWN). To get exposure to the emerging markets he often turns to the iShares MSCI Emerging Markets Index (EEM) and the Vanguard Emerging Market Stock ETF (VWO). He says limit orders are also appropriate for more narrowly focused commodity ETFs. For retirement accounts, he favors the iShares S&P GSCI Commodity-Indexed Trust (GSG), the United States Oil Fund ETF (USO) and, given the run-up in gold of late, the SPDR Gold Shares (GLD). He likes these funds because they're big and liquid, and the commodities-related ETFs offer a hedge against inflation, which Zhang foresees rising in the next 24-36 months.
A senior vice president-investments at UBS Financial Services, Jacobsen appreciates ETFs' flexibility and low cost, but she worries that investors don't always understand the pitfalls. "Some tend to think of ETFs as static portfolios that track an index, but that's not always what happens," says the Stamford, Conn.-based advisor. "There can be surprises, and when there are, they can be quite unfavorable."
A big problem is "tracking error"â??when an ETF doesn't match the returns of the securities it's intended to track. This can occur with thinly traded or commodity-based ETFs that attempt to mimic the underlying asset by purchasing derivatives. Commodity ETFs often buy futures contracts, locking in positions that may not track recent shifts in spot prices.
Investors must also pay heed to the individual securities an ETF owns and how they are weighted within it, Jacobsen says. ETFs that track a narrow equity sector might be heavily weighted in just two or three stocks, and a buyer may not realize that he already owns those shares. "ETFs are not a mindless thing to put in a portfolio; they need to be closely monitored," she says.
Generally, Jacobsen sticks with the biggest, least expensive, most liquid ETFs for investors looking to match the marketâ??since these have very little tracking error. She particularly likes the Rydex S&P Equal Weight Index (RSP), which gives equal weight to all the components of the S&P 500; also based on the S&P 500 but market-cap weighted, SPDRs (SPY) have consistently underperformed the RSP.
Jacobsen has $400 million in assets under management and a mix of retail and institutional clients. For the most sophisticated and risk-tolerant investors she will occasionally dip into leveraged ETFs, which are designed to amplify the moves of the underlying index. Some of her customers used them to play the recent stock rally. "They're good at catching a trend at a particular time, but leveraged ETFs are designed for the short term. They can be useful, but they're very volatile," she says. Daily monitoring is required.
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