Exchange Traded Funds (ETFs) are a relatively new (compared with many other securities like stocks or bonds) investment innovation. When they were first introduced, ETFs were designed as funds structured to track the value of an underlying asset or basket of assets with a low cost of management and administrative fees. Some of the earliest ETFs were “spyders” which was an EFT designed to track the returns of the S&P 500 index. Later ETFs were introduced to track just about any asset or asset class, whether an basket of stocks, an equity or other index, bonds or interest rates, commodities, volatility, cryptocurrencies, almost anything you can imagine. There are ETFs that provide returns on long positions, short positions or even leveraged positions to amplify potential returns. And appropriately enough given the 10th anniversary of the great financial crisis, there is now an ETF that allows investors to sell credit default swaps! So what are the risks, benefits and potential uses of ETFs in your portfolio?

Let’s start with the basics of how ETFs work and what differentiates them from a standard mutual fund. Unlike a standard open end mutual fund where shares are purchased at Net Asset Value (NAV) and the manager invests the proceeds into the underlying portfolio, ETFs are created by large investors known as authorized participants (APs). These APs will construct an underlying portfolio that mirrors the asset basket of the ETF, perhaps shares of stock that comprise an index or a particularly quantity of a commodity. The APs then transfers the basket of assets to the fund, which then creates newly issued shares of the ETF that are transferred back to the AP, which then sells them on the open market. In this way the underlying assets of the ETF closely mirror the index or asset the fund is tracking. For redemptions, the AP accumulates enough shares to represent the basket and then the shares are retired in the reverse transaction.

So now that we know the basics of how ETFs work, how can we use them in our investment portfolios and to help achieve our long-term financial goals? Perhaps a convenient way to look at this is to take the good and the bad of ETFs and see how those factors affect our view of these financial products.

Let’s start with the bad, the negative aspects of ETFs. Perhaps one of the first and most obvious negative aspects of ETFs is that these instruments are derivatives which subject you to being a creditor of the fund sponsor rather than a direct owner of the underlying assets. In most cases, this is not a significant concern since this situation is prevalent in most modern securities – similar to the fact that you don’t really own the stocks in your brokerage account, but instead own a claim against your broker for the shares, while your broker has a claim against DTCC for the shares. The only time this lack of ownership seems to be an issue is on certain ETFs, particularly in the precious metals arena where holders seek to own gold as insurance against a financial collapse and don’t want to end up as unsecured creditors in a worst-case scenario. But for most investors, the fact that you are not the legal owner of the underlying assets is not a significant cause for concern. Somewhat related to this concern surrounds the creditworthiness of the sponsor. Given that you are a creditor of the fund, it would be wise to ensure that you are dealing with large, well established sponsors, but it’s still a good idea to read the fine print within the fund agreements to understand your rights should problems ever occur with the sponsor. Finally, one of the biggest negatives regarding ETFs that I’ve heard is that they promote a lack of thinking and due diligence on the part of investors. When you buy an index ETF, you are buying every stock in the index, the great performers and the laggards. Unlike a portfolio of individual stocks, buying the index means you are being less selective than you might otherwise be. This may not be a huge problem for most investors, but it is something we should be aware of as we construct our portfolio.

As for the positives, there are three big advantages that I would call to your attention: liquidity, asset class diversification and hedging. Looking first at the liquidity issue, ETFs add trading liquidity from a practical perspective compared with alternatives like index mutual funds. For example, if you had a strategy to buy or sell the S&P 500 index following the announcement by the FOMC, you could actually trade an index ETF intraday compared with a typical index mutual fund which is purchased or sold at net asset value at the end of the trading day. The additional liquidity allows for intraday trading of index and other instruments to take advantage of volatility driven by market moving events. From an asset class diversification standpoint, ETFs can provide exposure to many asset classes that are more difficult to purchase directly. Investments in commodities, foreign currencies and emerging markets securities might be difficult if not impossible to invest in directly, but can easily be purchased in the form of an exchange traded ETF. This diversification into different asset classes can provide a reduction in return volatility over the long term. A third benefit closely related to diversification is the ability to effectively hedge portfolio investments. For many individual investors hedging might only consist of taking option positions against specific stock positions, but that hedging strategy is inherently limited to equities with adequate listed options trading. Trying to hedge a portfolio against increased volatility or broad market declines is much more difficult. With ETFs designed to provide returns that mirror short positions, the VIX, or inverse index positions to provide positive returns in the event of broad market declines. This provides broadly enhanced alternatives for individual investors to effectively provide portfolio insurance that used to be available only to institutional or high net worth investors.

ETFs are a relatively new innovation that can provide some significant flexibility in managing your portfolio. Whether employing more plain vanilla index ETFs or more complex ones, these instruments have the potential to enhance diversification, reduce volatility and improve overall returns on your portfolio.