Are ETFs Really Necessary? Pros and Cons of the Investment Craze

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NasDaqEverywhere you look, new exchange-traded funds are popping up. Many people think they're a must-have for a successful portfolio. But even though investors have poured more than $1 trillion into ETFs, the question remains: Do you really need them?

ETFs have come a long way in the past 20 years. With 1993's debut of the SPDR S&P 500 ETF (SPY), investors got their first chance to buy and sell shares of an index fund on the open market throughout the trading day. Slowly but surely, new ETFs that tracked other popular market indexes, including the Dow Jones Industrials (^DJI) and the Nasdaq 100, gained the interest of investors.

For most of those early ETFs, though, intraday trading was the real innovation. Mutual funds already tracked many of those indexes, giving investors alternatives to mirror their returns. But mutual funds only let you buy and sell once per day, and you were stuck with the closing price even if you placed your order early in the day.

In recent years, the number of ETFs on the market has exploded higher, with well over 1,000 funds available to investors. Now, ETFs track not just the best-known indexes, but also small niche markets that many typical investors may never have even heard of.

The Pros and Cons of ETFs

If you invest for the long haul, the daily trading aspects of ETFs aren't really important. Low costs, on the other hand, make ETFs great bargains for fee-conscious investors. Some discount brokers even offer ETFs to their customers without any commission, giving you much greater access to the vehicles and making them more viable for investors who take a little money out of each paycheck to invest.

Unfortunately, the fee realm is where many new ETFs fall short. You might think that tracking smaller parts of the market would reduce fees, because the ETF would have fewer stocks to buy and sell than those tracking broader market indexes. But in reality, the opposite is often true. Many niche ETFs charge fees that can be 10 times or more what you'll pay for a vanilla S&P 500 ETF.

Still, focused ETFs can give you exactly the exposure you want in a way that's difficult to find elsewhere, even with traditional mutual funds. That's why so many investors use them, especially in up-and-coming investment types like emerging-market stocks and bonds, as well as commodities and other alternative assets.


Pitfalls for the Unwary

You have to be careful with ETFs, though, as their simplicity can be misleading. One of the worst problems with some ETFs is when they fail to track the returns investors expect.

For instance, high-octane leveraged ETFs promise to give you amped-up exposure to a particular market, so if a market benchmark goes up a certain amount in a given day, the ETF might go up two or three times that much. But because those ETFs are keyed to daily returns, they usually don't provide those double- or triple-sized returns over longer periods of time. In fact, in some cases pairs of leveraged ETFs designed to provide opposite daily returns both produce losses for long-term shareholders.

Another set of investments to watch out for are commodity ETFs that use futures contracts. Especially in the oil and natural-gas realm, conditions in the futures markets make it impossible for the ETFs to track long-term changes in spot prices. That can wipe out your gains in a rising market and make your losses even worse when commodity prices fall.

You could put together a perfectly solid portfolio without ever investing in a single ETF, as you can put together on your own a combination of individual stocks and traditional mutual funds that reflects the portfolio of almost any stock ETF you could buy. That said, though, if you're choosy about sticking with only low-cost ETFs that beat their alternatives, then having ETFs in your portfolio can be a smart move.

Motley Fool contributor Dan Caplinger uses regular mutual funds and ETFs in harmony. He doesn't own any of the ones mentioned here. You can follow him on Twitter here. The Motley Fool has sold shares of SPDR S&P 500 short.


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GymmyKramir

Gymmy Kramir coming 2 U LIVE on the NYC Madd 4 Your Money show frum the home of Zucchini, the great grandaughter of Mussolini in Beano, Italy.
I just want 2 thank every1 again 4 all the cards and after receiving a standing ovation in Germany with Merkel, I understand that Daarck Knight may give me a reward. I’m touched. What has Gymmy done 2 deserve this & all these friends? How much better can it get?
Well, Hello Zucchini. It’s been a long time. Last time we met u could only crawl. Now look at how u have sprouted.
Boogawagarama
Let’s get to the horses head
Boogawagarama
Hit it Zucchini and knock em dead sweetheart.
OK. My husband Scoreggiare don’t take beano frum a no buddy and NYC Financial PIGG stinks worsa than a last yeara Miss Italee Geena Buttaroma. Geena my friend is a most beautiful seductress, but she can clear a town with a ripe 1 and she gotta a really low flash point. She Very Dangerous. Everybody here in town angry because hometown MADE Beano boyz La Cosa Nostra, with counterfeit trillion treasury’s, was a turned in by snitch. Zucchini was going 2 use the lira to get Geena degassed and some new plumbing.
Thank U Zucchini. I know how it hurts when u can’t help a friend.
Well, Look who iz here.
It’s Father Guido (applause and cheerz…………………)
Hey a Gymmy. Goulda 2 be here. We gott a 1 thing in a common. It’s a grease. We born a greazy and U greaze up for Daarck.
Yes Father, but u wood 2 because of the lumber.
No Gymmy. Father Guido prefers the fine spices of Italiana women, except a Geena. She a liddle 2 spicy.
Boogawagarama. And what other newz have u 4 us, O please tell.
Come herea Gymmy, let me givea U a hug. U know, whatza matter here Gymmy. U know whatta bugs me. U a Made guy like a me. Don’t acta stupido or I gonna pull on that yellow mustache. It’s NYC La Cosa Nostra = SEC+Hedge Funds+Brokerages still bringin in the lira, but they send NOTHING 2 Father 4 his new parish & parish maids on skates that make a the mass collections. NOTHING goulda, but only bad cheese coma out of NYC except Johnnie Z Italian Bakery. Here, they stuffa kanoleez with NYC financial PIGGS. They taste just a like regular kanoleez but they R SHORT, not much 2 them and kept in a freezer. We name a them a Frosted E-Clairvoyant. Itz a 4 PIGGS who can C the future, And they gonna get Geena AnD there is NO Beano that will help. R & D at the Beano Factory work round clock for better beano 2 help Geena. She gonna put everyone in NYC 2 sleep. And an insider hint, shhhhhhh – do not investa in NYC real estate. Once Geena is a done, everything is a worthless. And then Zucchini Mussolini will plant Italian Flag and we make a 1 Big Shoe & Tailor Factory out of NYC. We send NYC Financial PIGG out in river Ferry with best italiano shoez and eco friendly cement batter
4 a NEW view.
Tell it like it is Father. Wham. Bang. Thanx 4 that update and here iz a donation 4 the parish and those parish maids.
Thank a U Gymmy. Goulda Bless.
I am in Japan next. Sionara
J

May 21 2012 at 10:04 AM Report abuse rate up rate down Reply