Exchange-traded funds seem to be advertised as a magic bullet for whatever ails an investor. They’re easy to buy and sell. Many have low fees. What they hold is transparent. And because there are so many of them — more than 1,000 in the United States, according to Forefront Advisory — investors can invest in very specific ways, singling out telecommunication companies, for instance, or European government debt.
One of the recent claims made by proponents of E.T.F.’s is that they are ideal for the volatile markets we’re in. One reason is that the funds are essentially baskets of securities sold as one stock. And like a stock, the fund is priced throughout the day so it can be bought and sold more easily than a mutual fund. These funds are also so specific that they allow people to invest in particular niches. Investing in E.T.F.’s in general, the argument goes, allows some investors to reduce volatility, while allowing others to exploit swings in the market. But is this true? Can these funds really do for investors what their proponents say they can, or are they just another investment that goes up and down like any other?
E.T.F.’s, like all popular things, have vocal detractors. No doubt these people will send e-mail to note the funds that have shut down or failed to perform in line with the indexes they track. True, but I want to look specifically at the advantages and disadvantages of investing some portion of a high-net-worth portfolio in exchange-traded funds.
Proponents see benefits in a volatile market in investors’ ability to buy and sell the funds quickly and to focus on certain indexes or sectors.
“The one thing I think that E.T.F.’s allow you to do in a volatile market is divorce yourself from your emotions as an investor,” said Daniel Faucetta, principal of global exchange-traded funds strategies for Forefront Advisory. “We’ll hear from investors who say we love G.E. or Apple. That emotional attachment to a position can be harmful. It’s much easier to buy and sell an E.T.F. from an emotional standpoint.”
He said the firm’s models were meant to find trends. In doing so, he said, they often miss the first 10 percent on the upside and lose 10 percent on the downside. The strategy adapts to what is already happening, rather than trying to predict which might happen. Its goal is to outperform the MSCI All World Index, an index of global stock funds — it has done so by 1.5 percentage points over the last five years — but to do so with half the volatility.
Such an approach irks someone like John Calamos, founder of Calamos Investments and a proponent of a different low-volatility strategy. He considers exchange-traded funds the domain of a manager who has given up.
“He says, ‘I can’t pick stocks. I don’t know if Apple is any better than BP so I’ll just pick an E.T.F. and have both of them in there,’ ” Mr. Calamos said. “If I’m no good at picking stocks, am I better at picking groups of stocks? That’s silly. We believe active management works.”
His strategy, which relies heavily on convertible securities, was born out of a similarly rough time in the 1970s, and his two funds, meant to capitalize on volatile markets, were both up around 15 percent last year with fewer swings. He admits, though, that these strategies do not perform as well in less volatile markets.
Daniel Weiskopf, who runs Forefront’s E.T.F. strategy with Mr. Faucetta, said the best active managers might have an advantage in volatile markets, but finding the best ones could be difficult. He hews to the belief that 80 percent of the returns come from picking the sector and only 20 percent from the individual securities.
In terms of funds intended to limit losses, the options seem limited. There is the PowerShares BuyWrite E.T.F., which replicate a traditional covered call strategy to limit the depreciation of a stock in return for giving up some of its appreciation. And a 2008 University of Massachusetts study, “Collaring the Cube,” showed how a similar strategy could be applied with the popular Nasdaq exchange-traded fund, QQQQ.
Ben Marks, president of Marks Group Wealth Management, argued that a properly constructed basket of E.T.F.’s could be an effective hedge against market volatility in and of itself. This is the goal of his Alternative Strategy Portfolio, which currently consists of investments in eight separate funds.
“This portfolio is really meant to take the bumps out of the road,” he said. “It’s meant to be noncorrelated to equities and bonds.”
One recent addition was a fund focused on base metals in the belief that emerging markets like China are going to drive up metal prices — creating volatility in commodity prices — while a recent success was a fund that bet that European currencies would lose value against the dollar.
None of this is risk-free, and some exchange-traded fund. investments could create problems for investors far greater than a bit of volatility. One comes from leveraged funds and so-called inverse funds, which return the opposite of what an index does. The danger here comes if your assumption is wrong and instead of being down 5 percent the index being tracked is up 20 percent.
The more common risk is in people jumping on the exchange-traded fund bandwagon in the hope that it will save their portfolios.
“There are so many E.T.F.’s now and the industry has been booming, that they really have become a catchall,” said Joseph Jennings, investment director in Baltimore for PNC Wealth Management. “They’re a good tool to manage diversification and risk in a portfolio as long as the investor is aware of what he is buying.”
He pointed to a popular telecommunications fund that was meant to track that industry. Some 45 percent of its holdings were in AT&T and Verizon, making it not very broad. In other words, buyer beware.
