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Yoshikami: Should Your Portfolio Include ETFs?

Businessman reading the newspaper
Steve Hix | Somos Images | Corbis | Getty Images
Businessman reading the newspaper

The ETF industry has seen explosive growth in both the number of funds and the assets managed by these funds since the launch of the first ETF in 1993.

There are many reasons why ETFs have grown in popularity with investors but should your portfolio include ETFs?

You can gain exposure to Apple , Chevron , Vodafone, and many other individual positions without the excess concentration in these assets.

Over time, the ETF universe has grown to include more than just “plain vanilla” products and is now home to some offerings that are structurally much more complex and, in some cases, challenging to understand. As a result, risks associated with some ETF offerings have increased.

ETF Basics

An ETF is a financial instrument that is listed on an exchange and can be traded like regular stocks. It represents a basket of securities that typically track a market index such as the Standard & Poor’s 500 Index. In general, ETFs seek to replicate the market performance of a static basket of positions (though some new offerings provide limited position management). Like a mutual fund, an ETF is a way to invest in a professionally managed portfolio of securities. ETF assets allow investors to gain diversified exposure to financial assets across geographical regions, sectors and/or asset classes.

Benefits of ETFs

Cost-Advantage: ETFs typically charge lower fees than mutual funds. Additionally, there is no minimum investment requirement for investors, so one can buy as little as a single share (plus the broker's commission), and there are no expensive loads and cumbersome redemption fees. In an era of lower returns, fee reduction matters to investors.

Tax Efficiency: Mutual funds, when faced with shareholder redemptions, must sell underlying securities to raise the cash to pay shareholders. Any capital gains that are triggered by those transactions are passed on to the remaining shareholders. ETFs are less impacted by redemptions as the assets are traded for the most part in the secondary market.

Diversity and Flexibility: Unlike traditional open-end mutual funds, ETFs trade like stocks, so they can be bought and sold throughout the trading day as the price fluctuates. ETFs can also be bought on margin, sold short, or traded using stop orders and limit orders. In contrast, mutual funds trade only once during a trading session at the day’s close.

How Risky Are ETFs?

ETFs available in the marketplace today have in-creased in complexity as a result of financial institutions constantly designing and marketing innovative financial products in order to keep up with market conditions and global risk appetite. There has been an emergence of more innovative and sophisticated ETF structures, which has led to concerns about security risk.

Earlier this year, the Bank of International Settlements warned that there were uncomfortable parallels between the ETF industry and the market for Collateralized Debt Obligations (CDOs ). We share that concern and advise careful analysis of the risks inherent in synthetic ETF positions. Critics fear that by developing instruments that are too complex for most investors to understand, such as synthetic ETF products, ETF providers could possibly be sowing the seeds of a future financial crisis.

Synthetic ETFs are products that are not fully backed by the underlying instruments of the index it is trying to track. It is cheaper and easier for a bank to buy a swap from another bank that guarantees index returns than it is for them to replicate the index. Synthetic ETFs require asset service providers to play a vital role in ensuring that their collateral management programs are sophisticated. That role requires performing mark to market, checking and communicating with a swap counterparty to ask for more collateral if the derivative pricing has moved against them.

Other types of ETFs that are facing scrutiny are leveraged and inverse ETFs. Leveraged ETFs are designed to amplify the performance of the index or benchmark they track by using various financial instruments on margin. Higher returns could potentially mean increased risks. While the upside may look promising, the downside may be devastating especially in high volatility environments.

Bottom Line

Like any investment strategy, ETF assets must be understood before a purchase decision. Still, despite the learning curve required, ETF assets provide an opportunity for diversification within an investor's portfolio that can be a useful tool. Careful assessment of an ETF asset is necessary prior to any investment. This includes accessing the risks and potential benefits of the asset selected. The overwhelming benefits of ETF positions (reducing costs to investors' portfolios and providing an additional level of diversification) cannot be ignored.

Michael Yoshikami, Ph.D., CFP®, is CEO, Founder and Chairman of YCMNET's Investment Committee at YCMNET Advisors. Michael is a CNBC Contributor and appears regularly on the network. YCMNET is a San Francisco Bay Area-based independent money management firm that provides fee-based wealth management services to institutional investors and individual investors. The firm works with clients around the world. Michael was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009, 2010 and 2011. He oversees all investment and research activities of the firm and is actively engaged on a daily basis in the firm's securities analysis activities and determines the macro tactical asset allocation weightings for client portfolios. He works with YCMNET's investment team in integrating behavioral investing strategies with the firm's core fundamental perspective. Michael holds a Ph.D. in education, other advanced degrees, and holds the Certified Financial Planner® (CFP) designation.