Reuters Money

The following is an edited excerpt from Never Buy Another Stock Again: The Investing Portfolio that Will Preserve Your Wealth and Your Sanity, written by David Gaffen, who is the Reuters markets editor. It was printed with permission of FT Press, an imprint of Pearson.

One of the biggest growth industries in finance right now is in exchange-traded funds, and further growth in ETFs appears likely to come from several places.

Sector or country-specific ETFs and actively managed ETFs are likely to continue to be a growth area, along with perhaps a combination of the two (an actively managed ETF focusing on small-cap stocks, for instance).

The most popular sector ETFs are in natural resources and technology, although State Street, which sponsors the SPDRs ETF, has S&P sector ETFs for nine of the ten S&P sectors (telecommunications is the lone exception—it’s folded into another area); new ones continue to crop up.

For professional investors attempting to beat the market, they’re an ideal vehicle because they carry a relatively low cost and have tax efficiency, as David Kotok of Cumberland Advisors has pointed out. But John Bogle, in his book “The Little Book of Common-Sense Investing,” quoted (anonymously) a chief investment officer at an ETF company cautioning against “pin-pointed” bets on sectors, because they “still involve nearly as much risk as concentrated stock picks.” But that doesn’t mean they’re going to stop growing.

Like mutual funds, tech stocks, tech funds, and other hot investments that dominated the landscape for a time, the ETF world is turning into its own “app economy,” as Nicholas Colas, chief market strategist at BNY ConvergEx Group, puts it. This, by itself, is not necessarily a bad thing, but with more choices comes more confusion.

Another area where one can expect a growth spurt is in actively managed ETFs, first introduced by investor Harry Dent with his Dent Fund through AdvisorShares, which is now marketing other new actively managed exchange-traded funds. And so ETFs are starting to come full circle: While this is still designed for the same kind of tax efficiency and liquidity offered as most ETFs, now investors have the (supposed) benefit of active management—but the higher expenses to boot.

Dent’s fund carries an expense ratio of 1.56 percent, and if such a ratio becomes the norm with active ETFs, the low-cost advantages of the structure are suddenly out the window. Part of the fund’s expense ratio includes a 0.46 percentage point expense for the cost of holding other ETFs—those ETFs you could just buy on your own, particularly the index ETFs, which carry half the cost of this small component of the overall expense

And if the ETF doesn’t perform well, then what? That tax efficiency isn’t all that helpful with fund costs eating up returns in the first place.

Actively managed ETFs at this point are still in their infancy—but State Street, which produces the SPDRs, has already filed with regulators for the opening of an actively managed ETF, and they’re not alone; other major fund companies have done the same thing.

Naturally, though, providers of ETFs are concerned that there’s no track record for fund managers who would actively manage ETFs. John Gabriel, a Morningstar analyst, says this structure may take off once a prominent fund manager decides to start managing an ETF.

The other option fund companies have is to convert an existing mutual fund into an ETF structure, which would allow intraday trading, better tax treatment, and more liquidity, and from there, it would have an established track record as well. Of course, this doesn’t help you if you’re stuck with an ETF, once a mutual fund, which had a strong record of returns before you bought it, only to see the thing tank when you buy into it.

The rise of active management of ETFs also garners this question: What if there’s a run on an ETF? An actively managed ETF is only as good as its holdings, and at a time when professional investors are looking to game the market as much as possible, it won’t be long before there’s a cottage industry of people who pore over the published holdings of actively managed ETFs and find those with the most problematic portfolios. Now, that exchange-traded fund’s holdings may have changed if quarterly data is all that’s available, but markets have moved quickly before on less information—talk of hedge-fund redemptions is enough to send investors flocking out of vehicles that are much harder to abandon than something like an ETF.

What happens if a fund is discovered to have had two or three holdings that are suddenly blowing up? Investors will start selling indiscriminately, and unlike the sector ETF, which is going to go down or up based on fundamentals of the underlying sector, rumors may be enough to hit these ETFs hard. By contrast, runs on a mutual fund are more difficult. (To be sure, Gabriel of Morningstar says a run is unlikely, but statements like that have been made about other products before.)

With about 800 ETFs in existence now, there does not seem to be a limit to the number of flavors that can be invented. By no means is the ETF world anywhere near close to saturation, but the growth area would seem to have to be in actively managed ETFs.

Once that novelty has worn off, though, investors will find they’re buying another mutual fund. Sure, a more tax-efficient and liquid mutual fund, but a fund just the same, and investors are back to the same story: Reduce costs and buy the market, or try to chase performance and see how it all works out.

Boiling It Down

• ETFs are a great vehicle for quickly building a diversified portfolio in many assets, including stocks, bonds, commodities, and currencies.

• Take advantage of low-cost offers of free trading in ETFs to set up portfolios and to rebalance.

• Consider using ETFs for a big buy-and-hold purchase, such as an IRA rollover.

• Resist the temptation to trade frequently, no matter how many free trades you’re given—they will eventually run out.

• Treat actively managed ETFs the way you would an actively managed mutual fund: Look at the costs involved. Is there a cheaper option? Is there an advantage? More than likely, there probably is not.