Exchange Traded Funds: Still a Good Bet in 2013

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This article is a brief primer on exchange-traded funds, or ETFs, and the investment outlook for the coming year of economic uncertainty.

In 1989, ETFs first appeared in Canada as the Toronto Index Particpation Fund. Four years later, the first ETF touched down in US markets in the form of Standard and Poor’s 500 Depositary Receipts, also known as SPDRs or “spiders.”

Exchange-Traded Funds are essentially baskets of stocks bundled together to track the world’s largest markets. These investment vehicles were pitched to investors as a way to get into stocks without directly buying shares of companies.  Initially, ETFs were also referred to as “passive” investment vehicles while traditional mutual funds were actively managed.

Some of the advantages of ETFs included lower expense ratios, combined with the features of traditional stock investing, like short selling and options trading. And passive ETFs were considered part of a long-term investment strategy aimed at diversification and risk management.

By 2005, in order to gain market share and take advantage of technological innovation, ETF providers created more actively managed funds, like the Power Shares FTSE/RAFI US 1000 Portfolio. Now there are more than 1,400 ETFs to choose from, holding about $1.4 trillion in assets. And with that much money on the table, investors are faced with a whole new animal.

In 2012, the ETF sector had a banner year, as investors poured billions into these investments to hitch their wagon to the big gains that were made in the equity markets. Of course, much of those gains were fueled by the liquidity being injected by the world’s central bankers.

In the US, the Federal Reserve implemented a third round of monetary easing with a new $40 billion-a-month, open-ended, bond purchasing program (“QE3”). And it’s a well-worn investing adage that investors shouldn't fight the Fed. But the question remains as to what the long-term consequences of this endless easing will be, and how much longer the latest market rally last.

There is a growing narrative among some observers that the next few months could prove troublesome as the US government draws closer to the inevitability of sequestration. The mandated spending cuts could send shockwaves into the economy. Moreover, while the sovereign debt crisis in the Eurozone has been quiet, it might flare up again soon.

The bottom line: The equity markets could be headed for a correction, and ETFs will follow a downward trend.

In addition to these concerns, there is a new element of regulatory risk attached to actively managed ETFs: the SEC and Finra are conducting corollary probes into high-frequency trading in order to prevent another “flash crash” that erupted in the US market back in May 2010. While there is no evidence of any market manipulation in the ETF sector, it is uncertain what these probes may uncover.

So for those ETF investors who desire the benefits of diversification in an economy that is still shaky a prudent way to go is by sticking with larger, more stable funds that have fewer expenses and longer track records. But there are a variety of large cap, small cap, and emerging markets funds that can also serve as effective risk management tools.

And some of the funds provided by Vanguard may provide the needed combination of diversification and risk management that adheres to a long term investment view.

A large-cap ETF like the Vanguard Total Market ETF (NYSEMKT: VTI) boasted a 15.4% total return in 2012; however, its five year average was only 1.5%. As for a small-cap play, these funds tend to be more volatile than large caps, but the Vanguard Small-Cap ETF (NYSEMKT: VB) also had a 15.4% total return last year; its five-year average was 3.9%.

If the US markets face headwinds because of the impending sequester, investors may want to look offshore to emerging markets ETFs. But five year returns are not as solid. In 2012, the Vanguard MSCI Emerging Markets ETF (NYSEMKT: VWO) fund had a 14.9% total return, but a five year average of -2.3%.

Of course, there are many other investing options available in the ETF game, pegged to commodities, countries, and other market sectors. And it goes without saying that past performance is not indicative of future results. Investors should do their homework and consult with a bona fide financial advisor in developing a long term strategy that considers the speed bumps that may crop up this year.

kcolona has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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