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We're big fans of exchange-traded funds. They offer investors a cheap, sensible way to invest in such well-known market barometers as Standard & Poor's 500-stock index. But never underestimate Wall Street's ability to weave fine thread into an ill-fitting suit. Today's roster of more than 500 ETFs includes many funds that most investors can do without. After all, do you really need HealthShares Dermatology and Wound Care fund or CurrencyShares Swedish Krona Trust?
To be fair, these and other ETFs were created primarily for professional investors. But anyone can purchase them. And although simple ETFs that track stock indexes have generally served individual investors well over the past 14 years, the same may not be true for some of the exotic varieties that have been springing up lately. "A lot of them can be used incorrectly and have the potential to blow up your portfolio," says Jim Wiandt, publisher of Exchange-Traded Funds Report. Before adding one of these newbies to your portfolio, consider these issues:
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Narrow focus
The 22 stocks, most of them biotech companies, in HealthShares Dermatology and Wound Care (symbol HRW) have a total market value of $47 billion, roughly 0.2% of the $19-trillion value of all U.S. stocks. If you allocate just 5% of the U.S.-stock portion of your portfolio to this fund, you are overweighting a tiny slice of the market by a factor of 20.
The proliferation of narrowly focused funds that invest in niche areas such as water utilities and nanotechnology makes it easy -- too easy -- to get sidetracked into fad investing. If you want exposure to health stocks, better to buy a broad-based ETF, such as Health Care Select Sector SPDR (XLV), which tracks 54 stocks with a total market value of $1.6 trillion. Or go with SPDR S&P Biotech (XBI), which holds a broad array of biotech firms.
Untested strategies
Traditionally, indexing has been a relatively low-risk, low-cost strategy of buying a set of stocks and holding them for the long haul. But financial engineers have cooked up new types of indexes that change with economic conditions. ETFs that track these new-age indexes buy and sell stocks much more frequently than traditional index funds do.
For example, PowerShares Dynamic Market (PWC) tries to find stocks with "superior risk-return profiles." It does this by setting up an index that automatically selects stocks according to a computer-driven analysis of 25 value, risk and timing factors (not all of which are publicly disclosed). The index rejiggers its holdings every quarter.
The fund's strategy could prove to be a winner. Dynamic Market's 16% annualized return for the three years to June 1 beat the S&P 500's return by an average of more than three percentage points a year. But this and similar funds should not be confused with traditional index funds. The fund's annual turnover is more than 100%, so it holds stocks for less than a year, on average. Turnover for the S&P 500 is about 5%. The fund's annual expense ratio of 0.60% is more than seven times higher than the cheapest S&P 500 ETF (and that doesn't include the extra trading costs). Plus, it's hard to know whether its superior returns will persist over the long term. The fund is only four years old, and it lagged the S&P 500 by four percentage points in 2006.
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