Advisers best defense against misuse of ETFs

Exchange traded funds have boomed in the past few years. Last year, the number of ETFs climbed to 357, from 204 the previous year. ETF assets increased by 40.4% to $422.5 billion, from $300.8 billion in 2005, while net issuance of ETF shares totaled 73.02 billion versus 56.73 billion the previous year. By contrast, the number of mutual funds increased to 8,117 from 7,975, while such assets rose just 1.3% to $10.4 trillion. Clearly, ETFs now are fully accepted by investors, and therein lies a danger that financial advisers can help to protect against. ETFs, like power tools, are incredibly useful when used correctly, but dangerous when misused. Broad-based ETFs can provide tax efficiency and cheap diversification for long-term investors. Sector ETFs, those that invest in narrow market sectors such as health care, energy or heavy industry, provide cost-effective alternatives to actively managed portfolios. But naïve investors inadvertently may increase their risks if they use ETFs incorrectly. They may, for example, inadvertently greatly increase their exposure to certain market sectors, and even certain stocks, if they do not carefully examine the stocks in their existing portfolios before adding sector ETFs. Some of the sector ETFs hold relatively few stocks, and a few stocks may account for a large part of the market capitalization of the fund. Movements in the prices of these few stocks can significantly affect the prices of the ETF shares. As broad market indexes get sliced thinner and thinner to produce new ETFs, and as ETFs based on new indexes sprout, the risks to the ill-informed investor grow. Financial advisers, whether they use them or not, have a duty to inform themselves about the structure, the strengths and the weaknesses of the new ETFs and how they should be used in portfolios. They should then educate their clients on the safe use of ETFs.