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Should you invest in ETFs?

Exchange traded funds, or ETFs, have exploded in popularity since their debut in 1993. Since that time, investors have input over $1 trillion into ETFs. But while ETFs can be great ways to diversify a portfolio, the increase in different types of ETFs can make investing complicated and increasingly risky.

ETFs are very much like a mutual fund in that they are bundles of stocks, bonds, or some other asset that can be bought and sold through a broker. As such, they can provide easy diversification within a given asset class. However, while mutual funds are traded once per day, ETFs are bought and sold throughout the day, much like a stock. As a result, where mutual fund prices are set to their net asset value daily, ETFs can and do deviate from their net asset value as they are traded. Generally though, these deviations are small.

Most ETFs are index funds, meaning that they are meant to track some index, such as the S&P 500, which measures the 500 largest U.S. stocks or the MSCIA Emerging Markets Index, which measures stock performance in global emerging markets. Like mutual funds, ETFs can provide quick exposure to a broadly diversified portfolio within these asset classes, without the trouble of buying small lots of individual securities. Also, since index funds and ETFs that track an index passively follow that index, expenses are generally very low.

In addition to diversification and low costs, ETFs provide many other advantages. As with index funds, ETFs are generally tax efficient. Since the components of the underlying index don't change very often, ETFs generally pay out limited capital gains. But, ETFs provide a further tax efficiency. While mutual fund indices sell assets to pay out investors leaving the fund, generating capital gains, when ETF investors leave the fund, they sell the ETF to another investor, which doesn't result in capital gains for the fund.

Another advantage of an ETF is their ability to be traded like a stock. Since they are traded on the market, investors can carry out more sophisticated trades including selling short, limit orders, buying on margin, or stop-loss orders. Many ETFs also have the ability to have options written against them. Mutual funds do not offer these features.

With these advantages, ETFs can be an important part of building a diversified portfolio. However, caution must be used. As ETFs have proliferated, fund sponsors have introduced funds that track narrower and narrower market segments. For example, an ETF that covers a small developing country may be tied closely to one or two stocks, introducing tremendous risk.

Additionally, in 2008, the U.S. Securities and Exchange Commission, authorized the creation of actively managed ETFs. With actively managed ETFs, a portfolio manager seeks to create a return in excess of a benchmark index, as opposed to passively tracking the index. This strategy often results in increased trading actively, which generates capital gains, negating some of the tax efficiency advantages of ETFs that track an index.

Despite these risks, ETFs can be an appealing option for investors trying to build a portfolio. But, before investing in an ETF, investors should carefully evaluate its risk and consult their investment advisor about the suitability of an ETF for their portfolio.
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Helen Raleigh

Helen Raleigh, CFA is the owner and Chief Investment Officer for Red Meadow Capital, LLC, a Colorado Registered fee-only Investment Advisory Firm, which focusing on providing clients with honest and sound financial advice. She has more than 10 years experience in the financial services industry ranging from pension funds to risk management. Helen is the author of an autobiography, "Confucius Never Said."  She writes insightful columns and blogs for a variety of media outlets and her writings can be found at the Wall Street Journal, the CFA Magazine, the Denver Post and her blog postings. She can be reached at: helen.raleigh@redmeadowadvisors.com

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