In the mid 1990s, exchange-traded funds came riding down Wall Street like Clint Eastwood in an old spaghetti western—fearless and ready to take on the bandits who had been terrorizing the townsfolk. For years prior to the arrival of ETFs, average investors were held hostage by obscene fees while mutual fund robbers brashly collected their booty, threw back some expensive whiskey, and then shamelessly shot up the town.
In 1989 the first ETF—Index Participation Shares—came to the rescue. This S&P 500 proxy traded on the American Stock Exchange but was quickly gunned down by the Chicago Mercantile Exchange who quickly perceived the threat. It wasn't until 1993 that the real gunslinger rode into town and changed the order of the fund industry forever.
The Good ETFs. In 1993, SPDR S&P 500 (symbol SPY) was launched on the New York Stock Exchange. Known as SPDRs or "Spiders," the fund became the largest ETF in the world. In just over 15 years, there are now close to 1000 ETFs with more than $1 trillion in assets and growing at a breakneck pace close to 30 percent year-over-year.
But just when ETFs were winning the day, the ETF industry drifted from its sound mooring after the SEC approved a redefinition of the term "index" in 2003. Before then, ETFs were limited to holding baskets of stocks that tracked broad market indices such as the S&P 500 or MSCI EAFE for foreign developed country markets. After 2003, the SEC allowed ETF providers to create any set of guiding rules to form newfangled "indices." This changed the definition of an index and allowed the Wall Street crowd to run wild creating the latest, greatest "index" de jour, cluttering the universe of good ETFs with a never-ending wave of convoluted, bad, and in some cases, downright ugly ETFs.
When trying to make sense of the world of ETFs, there are five simple principles that will guide you to the good and away from the bad and ugly:
The bad and the ugly ETFs. With new indexes popping up daily, the original "purity" of ETFs as suitable building blocks for asset allocation has been polluted. One of the most extreme examples of this is an ETF released in 2007 (now closed) by FocusShares, which developed an index of mid- and large-sized companies consisting of casinos, producers of beer and malt liquors, distillers, vintners, as well as cigarette manufacturers, and called it a "sin" index. Below is a list of potentially bad and ugly ETF categories to watch out for:
When it comes to ETFs, invest in the good and avoid the bad and ugly. As tempting as the newfangled ETFs can be, the details reveal serious investment risks. By sticking with the five principles to finding good ETFs you can invest with confidence knowing that you have kept the bandit out of your portfolio.
Steve Beck is cofounder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.
Corrected 3/10/2011: A previous version of this article incorrectly stated that the FocusShares "sin" ETF is active. The fund closed in 2008 and no longer trades at this time.