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Why ETF Investors Need to Do Their Homework

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ETFs are great investment tools, but there’s a lot to consider before jumping in.

This week I spoke at the 4th annual Inside ETFs Conference in Hollywood, Fla. It was an extremely well-attended event with over 900 attendees, live broadcasts from CNBC, and information booths from every major ETF vendor.

I’m a huge fan of exchange-traded funds—I’ve been managing portfolios composed entirely of ETFs for almost 10 years. I think the ever-increasing size of the ETF market, and the number of new issuances in registration, proves ETFs are here not only to stay, but to dominate. Actively managing passive investments is a fantastic way to construct globally diversified portfolios that are cost-effective and tax-efficient.

However, for all their good and effectiveness, ETFs are fraught with peril for the uninformed investor and adviser. Here are a few reasons why:

A huge ETF universe.

There are over 1,200 ETFs currently trading on the exchanges and almost 800 undergoing registration to begin trading soon. There are more than $1 trillion in assets invested in ETFs, and I would not be surprised if that number was a bit light.

Even though the ETF arena is increasing, many products will fail. One little nugget I picked up at the conference was that only 10 ETFs closed in 2007 compared with the 150 that have closed in the three years since. With 52 weeks in a year, that’s about one a week. I don’t think that’s a very good sign for the ones attempting to start up, so stay away from the small ones. I listened to one company pitch me an ETF they recently launched, and when I got a chance to ask a question—10 minutes into the salesman’s diatribe—I asked, “How much money is in this ETF?” His answer: $9 million. Were it not for my dress shoes, I might have qualified for the 2012 Summer Olympic Games in the 100-meter dash.

Performance may vary.

Just because two ETFs track the same sector does not mean they will have the same performance. That goes for both the short term and the long term. This may come as a surprise to many investors. For instance, two ETFs that track the financial sector may not perform the same way.

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Why? One reason is the difference in the way the ETF is built. If one ETF is built by buying every stock in the index it is designed to track, and another attempts to replicate the performance of the index without buying all the stocks in that index, the performance will be different if the replication strategy does not work exactly right. Pick the index you want to track, and then study the tracking error of each associated ETF. Picking the ETF that most accurately mimics the index will help eliminate surprises.

Actively-managed ETFs.

ETFs have moved from being simple and elegant tools used to passively track an index into the world of active management. I saw a slew of new offerings that allow investors to buy actively-managed ETFs. That’s OK, so long as investors understand that they are investing in something that is no longer passive.

Historically, one of the beauties of ETF investing was that an investor or an adviser could pick sectors of the market they thought would outperform in an economic cycle. While that is still possible, many new ETFs are attempting to add a component of management to try to increase returns. It is important to understand that an actively-managed ETF is exactly that—actively managed—and therefore may not track a particular index.

Don’t fall for a sales story. Make sure you understand the approach before investing in any actively-managed ETF. There are a ton of actively-managed ETFs in registration, and the ETF market is only going to get more and more popular. As I said, I’m an ETF fan, but increasing popularity also means ETFs will not be as straightforward as they once were. Taxation and fees will complicate the picture.

As always, educate yourself on any ETF you may be buying.

David B. Armstrong, CFA, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service wealth management firm. Monument Wealth Management is backed by LPL Financial, the independent broker-dealer and Registered Investment Advisor. David has been named one of America’s Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010 based on assets under management) and has been interviewed by several national media sources for the past several years. David and Monument Wealth Management can be followed on their blog “Off The Wall,” their Twitter account @MonumentWealth, and on their Facebook page.

ETFs are typically registered as unit investment trusts (UITs) or open-end investment companies. ETFs trade on the major exchanges and shares can be bought and sold throughout the trading day at the current market price.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. All performance referenced is historical and is no guarantee of future results. The S&P 500 index is an unmanaged index and cannot be invested into directly.

Principal Risk: An investment in an Exchange Traded Fund (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts.

Investors should consider the investment objectives, risks, charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.

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