Interest Rates Rising

Are ETFs the of funds?

Anna Robaton, Special to

Over the past two decades, financial advisors, institutions and do-it-yourself investors have pumped billions of dollars into exchange-traded funds, turning what was once an obscure corner of the investment business into "the of the fund world," as one expert sees it.

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Last year U.S.-listed ETFs had net inflows of a little more than $188 billion, just shy of a record $190 billion haul in 2012, according to research firm Morningstar. Given the U.S. stock market's eye-popping performance last year, it is not surprising that U.S. equity ETFs captured the largest amount of investment dollars among all categories of ETFs, with inflows of nearly $98 billion in 2013.

Yet ETFs have also become a popular vehicle for investors chasing higher yields in the fixed-income market or seeking downside protection in what is expected to be a long bear market for bonds.

While investors can gain exposure to the fixed-income market through mutual funds, ETFs generally have lower management fees because most are passively managed funds tracking an index or a portion of one. Passively managed funds don't incur the same level of expenses as funds that regularly buy and sell securities in an effort to beat the market.

(Read more: Expert offers tips on handling rising rates)

The low-cost nature of ETFs has boosted their appeal at a time when many investors are bracing for diminished returns on the bond side of their portfolios. According to Morningstar, ETFs have an average annual expense ratio of about 0.6 percent. By comparison, passively managed mutual funds have an average yearly expense ratio of about 0.8 percent. The average expense ratio for actively managed funds is nearly 1.3 percent.

"ETFs have become even more attractive in the current environment because the expectation of making big money in the fixed-income market is not really on the table," said Christopher Krell, a certified financial planner and principal at Cassaday & Co.

In recent years ETFs have proliferated, both in number and in type. Since 2010, some 700 new ETFs have been launched, creating confusion among investors but also greater access to a wide variety of asset classes. Unlike mutual funds, ETFs trade on a major stock exchange and can be bought or sold at any time during the trading day.

"ETFs are sort of the of the fund world," said Ben Johnson, Morningstar's director of passive funds research. "They have had a leveling effect, offering both individual investors and large institutions access to a wide variety of exposures at very low prices."

(Read more: Inflation risk low, investors shun TIPS)

With many fixed-income investors spooked by the prospect of rising rates, short-duration bond ETFs have gained popularity, experts say.

Such funds might invest strictly in corporate or government debt or even in junk bonds. Duration measures the overall interest-rate sensitivity of a bond portfolio. Higher-duration funds tend to get hit harder when interest rates rise. Bond prices and interest rates move in opposite directions.

Investors have also flocked to bank-loan ETFs, which invest in floating-rate bank loans made to companies rated below investment grade. Investors have been drawn to the funds because they generally offer higher yields than corporate- and government-bond funds and protection against rising rates. Bonds generally pay a fixed interest rate (or coupon), but floating-rate bank debt adjusts periodically as short-term rates rise or fall.

Nonetheless, bank-loan funds have a level credit risk that is on par with junk-bond funds, Johnson said.

Many investors may be unaware of the added risk they are taking in an effort to achieve higher returns and downside protection against rising rates.

"Whether people are aware of just how much incremental risk they are taking to achieve those two benefits is up for debate," Johnson said.

(Read more: Rates rise aside, bonds still a good bet)

For many advisors, the allure of ETFs is closely tied to the flexibility they offer, allowing investors to target very narrow segments of the fixed-income and equities markets.

For instance, target-maturity bond ETFs invest in bonds (or baskets of bonds tied to an index) that mature in the same year. The funds, which liquidate when their underlying assets reach maturity, are designed to appeal to investors who want the type of certainty—and regular income—that comes with buying and holding bonds to maturity and greater diversification than they could achieve on their own.

Because of the way you are able to manipulate small segments of the market, you can build what you want using ETFs.
Christopher Krell
certified financial planner and principal at Cassaday & Co.

However, the funds don't have a guaranteed return. Investors could end up getting back less than their original principal if one or more of the bonds in a portfolio defaults, or if they cash out before a given fund's expiration date. As with other types of bond funds, shorter-duration, target-maturity ETFs are less sensitive to rising interest rates than their longer-maturity counterparts.

"Because of the way you are able to manipulate small segments of the market, you can build what you want using ETFs," said Krell of Cassaday & Co. "You can literally pick your exact bond maturities and credit qualities through ETFs."

Many advisors' and investors' attitude toward ETFs and mutual funds is closely tied to their belief in passive vs. active investing. The long-running debate around the two types of investing centers on whether active fund managers are worth the added cost. However, the cost advantages of ETFs have been somewhat eroded by the large number of actively managed ETFs that have hit the market.

(Read more: Bond outlook dim, investors eye alternatives)

Some advisors have built their practices around ETFs, while others use the funds in combination with other investment vehicles.

"There are some asset classes where it does pay to invest in an actively managed fund," said Catherine Valega, a certified financial planner and owner of Green Bridge Wealth Management. "In some cases, it can make a difference to kick the tires."

—By Anna Robaton, Special to