An investment sea change has been occurring in the past few years: Mutual fund investors have been shifting some or all of their assets to passively managed vehicles.1 For many, exchange-traded funds (ETFs) have become the vehicle of choice.

"An increasing number of investors are turning to ETFs to gain exposure to specific markets or to complement other holdings in their portfolios," says Mariana F. Bush, CFA, a senior analyst with Wells Fargo Advisors.

And many of those investors have found plenty to like in the rapidly maturing field of ETFs. Since the first ETF was launched in 1993, the field has grown to nearly 1,200 different ETFs, with combined assets of $1.193 trillion as of March 31, 2012, according to the Investment Company Institute.2

Built Like a Fund, Traded Like a Stock

ETFs are a type of exchange-traded product (ETP), which is essentially what it sounds like: an investment that trades on exchanges. ETFs are generally designed to mirror the performance of certain market indexes, so they tend to be passively managed. A few actively managed ETFs exist, but when most people discuss ETFs, they're referring to the index-based type.

Like mutual funds, most ETFs are registered investment companies. And like index mutual funds, passively managed ETFs attempt to mirror the performance of an index. Those indexes may reflect exposure to domestic or international markets; equity, fixed income, commodity or currency markets; or a broad or narrow exposure to those markets.

Unlike mutual funds, however, ETFs trade on exchanges and can be bought and sold at market prices throughout the day during market hours, like stocks. ETFs typically list their current holdings on a daily basis, whereas mutual funds generally disclose their holdings every quarter.

"This transparency and trading flexibility are important to investors who want to know how much an ETF costs and what it is investing in before they buy or sell shares," Bush says. "These advantages can be particularly critical in highly volatile markets, since investors can place ETF trades using limit and stop orders to potentially mitigate risk and minimize losses."

ETFs can also offer an easy way to gain exposure to particular areas of the market.

"Some investors just want to integrate a broad mix of stocks, such as those included in the S&P 500 index," Bush says. "Others are interested in taking a targeted — but still cost-efficient — approach to an investing theme, such as the potential for a region, country or industry to outperform the market. ETFs can offer a way for an investor to achieve potentially diverse exposure to that particular segment of the market."

Other Uses — and Considerations

Another advantage of ETFs is that the investment minimum is one share.3 This makes it easy for investors to try out investment themes or create targeted allocations without a significant investment of capital.

ETFs may be more tax-efficient than actively managed funds. ETFs may create and redeem their shares in kind, rather than in cash, which can help them avoid distributing year-end capital gains the way many mutual funds do. This is particularly true for more seasoned and liquid ETFs.

But like any powerful tool, ETFs need to be handled carefully. In particular, investors should understand exactly what a given ETF holds and how its underlying index really works during particular market environments.

"For example, investors must understand the different return components of futures-based ETFs," Bush cautions. "The way futures contracts work is different from how stocks behave. The same goes for ETFs that involve leverage. They can magnify or minimize market movements, and the mechanisms for how they do that can be complex. Investors must understand the drivers of performance (or causes of underperformance) with those more complicated ETFs."

Evaluating ETFs

You should take the time to understand exactly what you're buying and how it's likely to behave under different conditions. Working with your financial adviser to select appropriate ETFs is likely to involve more than just a review of performance and expenses. Among other things, you'll want to look at an individual ETF's exposure and how it fits into the rest of your portfolio.

You'll also want to examine a given ETF's liquidity. This tends to be less of an issue for popular, heavily traded ETFs, but less liquid ETFs may be thinly traded and difficult to trade at a price that makes sense for your investment strategy. Your financial adviser, who has access to our traders, can guide your trading execution.

ETFs may be an attractive option if you want to diversify your portfolio with exposure to additional asset classes and market sectors, but it's important for you to understand their unique characteristics.

When asked directly whether she believes ETFs are the new mutual funds, Bush answers with a qualified yes. "For investors who take the time to understand what ETFs can and can't do and what they hold, ETFs offer benefits that justify making them a cornerstone of an individual's portfolio."

1. Tom Lydon, “Are Shifting Demographics Driving ETF Growth?” Yahoo! Finance, 10 May 2012
2. Investment Company Institute, “Exchange-Traded Fund Assets, March 2012,” 24 April 2012
3. NYSE Euronext. ETFs FAQ, 2009

Exchange-Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed, or sold, may be worth more or less than their original cost.

Shares of ETFs are bought and sold at market price which may differ significantly from the ETF's net asset value and are not individually redeemed from the fund. Only "authorized participants" can purchase and redeem directly in the funds creation units, typically consisting of a block of 50,000 shares. Ordinary brokerage commissions for purchases and sales may apply which could reduce returns.

Index-based ETFs seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.

As Wells Fargo Advisors does not render tax advice, you should consult with a tax adviser before making any investment decisions which could have tax consequences. This article was written by Wells Fargo Advisors and provided courtesy of Jonathan Buoni, financial adviser, in Springfield, Mass., at 413-755-1171.

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