It's raining ETFs. Will investors need an umbrella?
The number of exchange-traded funds more than doubled, to 629, last year, while total assets increased 45 percent, to $608 billion.
International stock index ETFs attracted the most money, followed by growth-stock, fixed-income and commodities ETFs.
Expect this growth to slow this year, clouded by the stormy markets. The silver lining, however, is an opportunity for a bargain-hunter ETF strategy.
Traded on exchanges during market hours, ETFs replicate market indexes for low-cost diversification. There's no minimum investment or penalties for redeeming. Annual fees are generally lower than those of mutual funds, though you do pay trading fees.
While broad-index ETFs are used to build a foundation for an individual portfolio, the greatest growth opportunities are in riskier specialized offerings. For example, iPath MSCI India Index (INP) was up 86 percent last year; Market Vectors Steel ETF (SLX) 84 percent; and iShares MSCI Brazil Index (EWZ) 75 percent, according to Morningstar Inc.
"In 2007, ETFs went from being vehicles that people were just discovering to being fully discovered," said Tom Anderson, head of strategy and research for Boston-based State Street Global Advisors, one of the largest ETF managers. "They're being used as a core portion of portfolios, with some investors building all-ETF portfolios because they can get pretty much every type of equity exposure they're looking for."
ETFs invest in bonds: State Street rolled out the first municipal bond ETF last year, the SPDR Lehman Municipal Bond ETF (TFI) that tracks the long-term tax-exempt bond market. In junk bonds, it introduced SPDR Lehman High Yield Bond ETF (JNK).
ETFs can be trendy: Claymore/LGA Green (GRN) tracks the Light Green Eco Index of 225 companies with the best combination of environmental performance trends in their industries. It is down 8 percent this year.
ETFs can be finite: FocusShares ISE-Revere Wal-Mart Supplier (WSI) invests in stocks of companies deriving a substantial portion of their revenues from Wal-Mart Stores. It is down 9 percent this year.
As with all investments, market climate makes a difference.
"If the market persists in a bearish mode, we will begin to see a contraction, with some ETFs or ETF families removed from the market," said Jim Lowell, editor in chief of The Forbes ETF Advisor and independent Fidelity Investors newsletters in Watertown, Mass. "Since it's going to be a tough year, our model portfolios are holding around 10 different ETFs to cover as many different areas within a market space as possible."
The market will deliver some of the best "bargain-basement" opportunities of the last five years, Lowell said. He urged investors to build toward the near-term "prize," which he believes is the fourth quarter of 2008, and capitalize on companies that will benefit most from the international economy.
Lowell's recommended ETF growth portfolio is composed of iShares MSCI Emerging Markets (EEM); iShares iBoxx High Yield Corporate Bond (HYG); PowerShares QQQ (QQQQ); iShares MSCI EAFE Index (EFA); iShares S&P Global Healthcare Sector (IXJ); iShares Dow Jones U.S. Market Index (IYY); iShares S&P 100 (OEF); iShares S&P Global Consumer Staples (KXI); and iShares Lehman Short Treasury Bond (SHV).
"There are a lot of cheap ETFs out there, and the farther up the market-capitalization ladder you go, the more reasonably priced they are," said Jeffrey Ptak, director of exchange-traded securities analysis for Morningstar in Chicago. "It is fair to be vigilant about the economy and market, but we evaluate ETFs from a long-term perspective."
Bond ETFs, actively managed ETFs and further expansion into foreign ETFs are newer trends, Ptak said. Investors must understand their objectives, risk tolerance and whether their current portfolio matches up, he said. Then they can "whittle down" the ETF universe to find those that suit them among the funds trading at a discount to their actual worth.
Among financial-services ETFs discounted by the subprime debacle, Ptak recommends KBW Bank ETF (KBE), Regional Bank HOLDRs (RKH) and iShares Dow Jones U.S. Financial Services (IYG). Consumer-related suggestions are SPDR S&P Retail (XRT) and PowerShares Dynamic Retail (PMR), along with diversified choices Claymore/Great Companies Large-Cap Growth (XGC) and PowerShares High Growth Rate Dividend Achievers (PHJ).
"The only caution I have with ETFs is that in a market with the volatility we've had recently, you experience the full impact of the indexes," said Ray Ferrara, president and chief executive of ProVise Management Group LLC in Clearwater, Fla. "If you have a good active portfolio manager instead, you don't own the full index and hopefully the manager does a good job of cushioning down markets for you."
In client portfolios where Ferrara includes ETFs, he uses them as the core portion, especially when clients are particularly sensitive to fees. He adds some actively managed funds as satellites in the clients' overall holdings.
Could these low-cost ETFs someday supplant conventional index mutual funds?
"We're seeing at least the tip of that iceberg, which was evident when Vanguard Group entered the ETF space last year with ETFs that cannibalized its existing index funds' book of business," Lowell said, referring to the industry's index mutual fund leader. "For the future, as goes Vanguard, so will go the index fund business because it is the one most vulnerable to ETFs."
Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, P.O. Box 874702, Tempe, AZ 85287-4702, or by e-mail at andrewinv@aol.com.