ABCs Of ETFs: Crowded Field

With a flood of new exchange-traded funds on the market – and hundreds more on the way – it’s becoming more difficult, and increasingly important, for investors to do their homework before diving in.

Exchange-traded funds, which resemble index-tracking mutual funds but trade on an exchange like stocks, have long been lauded for their simplicity. They provide individual investors with a cheap and tax-efficient way to easily access broad chunks of the market, which can be used as the building blocks of a diversified portfolio.

Now, more ETF providers are launching products that slice the market into narrow and often esoteric slices, which some critics say are ripe for misuse. One ETF even picks stocks based on the value of companies' intellectual property. Further complicating matters are newer ETFs that might cover wider pieces of the market, but are based on indices that rely on unconventional methodologies that haven’t stood the test of time.

“The lesson is that the further you get away from broad-based diversified core ETFs and indexes that are just aiming to track a broad swath of the market, the more due diligence you have to do,” said Dan Culloton, a senior analyst with Morningstar. “What’s dizzying are the many introductions, innovations and trying to figure out what makes sense and what’s a gimmick.”

The industry has come a long way since the first ETF was launched in 1993. Though still a small piece of the $8.2 trillion mutual fund industry, ETFs have surged in popularity in recent years. There are now 458 exchange-traded products with about $447.6 billion in assets, according to Morgan Stanley. That’s nearly double the assets and triple the number of products available just three years ago. And there are another 364 products in the works.

While a wider selection of products may have opened up many corners of the market that were previously inaccessible to the average investor -- whether its commodities or a wide range of foreign currencies – some new products don’t necessarily don’t tout the same super low fees, diversification and tax advantages as their ETF ancestors.

How does an investor sort through the fray? Know what you own.

“Read the prospectus, that has a lot of information, and I would pay attention to the expense ratio – lower is always better,” said David Elan, a principal with Windward Investment Management, a Boston firm that uses ETF portfolios for clients. “I’d also pay very close attention to what the ETFs holdings are.”