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The Best Kind of ETFs Are Plain-Vanilla

If exchange-traded funds (ETFs) were food, they’d be the best thing since sliced bread. That’s demonstrated by the fact that since their introduction in 1993, investors have been buying them like hot cakes. Apologies for the saturation of food metaphors, but it’s meant to represent the excess ETF choices now available.

At year-end 2013, there were 1,294 funds and around $1.7 trillion in assets in the U.S. ETF market, according to the Investment Company Institute. Compare that to 2002 when the market held just 113 funds and $102 billion in assets. Another sign of a booming market is the $180 billion in ETF shares issued in 2013, slightly less than the all-time high of $185 billion issued in 2012.

The popularity can be attributed to more investors favoring passive investments like index funds. The majority of ETFs are similar to index funds in that they track market benchmarks, and they are generally low cost. Some ETFs are even cheaper than a comparable index fund. Investors may be also attracted to their flexibility, as they are traded throughout the day, and a unique tax feature that allows the ETF manager to trade shares for underlying securities, which the IRS doesn’t recognize as a taxable event. This reduces capital gains distributions at the end of the year. 

However, the high demand for ETFs has spurred providers to offer more variety, which isn’t necessarily a good thing. Although a small portion of the overall marketplace, actively managed ETFs — which attempt to beat the market — are being released in greater numbers. Additionally, you can find alternative ETFs, such as “smart beta” ETFs, that don’t weight their stock holdings based on market capitalization, unlike traditional market indexes. Instead, they attempt to beat the market by apportioning stocks by other factors such as company size, earnings to book ratios and price momentum.

There are even socially responsible ETFs. Although charity is admirable, leaving your financial goals up to the performance of companies that provide the best workplace equality or have reduced their carbon footprint isn’t a good idea. You’re better off taking some proceeds from your portfolio and gifting them directly to such organizations.

Narrow and exotic ETFs typically mean greater risk and higher cost – two things retirement investors need to manage as best possible. ETFs that select securities based on highly particular characteristics, for example dividend payments or geographic location, often lack diversification, making them and your portfolio more sensitive to the impact of a market downturn. 

In regards to cost, consider the average expense ratio for actively managed stock ETFs is 0.58%, according to research firm XTF Inc. Compare that to the Vanguard Total Stock Market ETF, which charges 0.05%. That’s a potential cost difference of around 0.5%.

This isn’t to say all actively managed ETFs are overpriced. However, a potential 0.5% difference in cost adds up over time. As we know, the more you pay, the less you keep of what you earn. To see how much, let’s say you are investing for retirement, and you need to withdraw cash from your portfolio. If you were to invest $1 million, an additional 0.5% in investment costs would result in $5,000 less in spending money each year. 

You can reasonably expect all the exotic ETFs with various bells and whistles to come with plenty of hype. Investors need to exercise caution and not automatically assume the ETF label signifies a market-tracking fund. Caveat emptor (buyer beware) to the do-it-yourself ETF investor.

It’s important not to lose sight of the forest for the trees. The type of funds in your portfolio isn’t what matters most. You must first determine what asset allocation is appropriate for your financial goals; then, what asset classes you need in your portfolio and what investments best represent them.

Smart investors recognize market fads, and the usual added risk and costs they bring. Stick with a tenet of long-term investing – the return of the market at the lowest cost possible is better in the long run. That should be your bread and butter.

Get the scoop on how index funds and ETFs work in your portfolio by downloading our free eBook: A Primer on Index Investing.