By now most investors are aware of Exchange Traded Funds or ETFs as they are commonly called. ETFs, in their most basic form, are publicly-traded funds designed to track broad market indices such as the Standard & Poor’s 500 or the MSCI World Stock Index. Buying shares in an ETF is therefore equivalent to purchasing a basket of shares in a portfolio that tracks the yield and return of its underlying index.

Many years prior to the advent of Exchange Traded Funds retail investors had been able to access market benchmarks through traditional indexed mutual funds, but the selection was limited and trading much more restricted. For example, one important difference between the two is that ETFs trade throughout the day whereas mutual funds are priced and therefore ‘traded’ just once per day, only at the closing price.

By being available for trading all day long, skilled managers have more opportunities to be in or out of positions without having to wait for the closing price. Constant liquidity also allows managers to pursue more sophisticated investment strategies such as entering limit orders and utilising options writing programmes to enhance the total return potential of a portfolio.

Traditional index mutual funds began gaining popularity in the late 1970s when investment managers found the need to match the S&P 500 index for all or a portion of their assets. ETFs are newer to the scene and although they have been around since the early 1980s, these funds have really taken off in just the past decade. From 2003 to the end of last year, ETF assets have burgeoned from $151 billion to $1.97 trillion according to an Investment Company Institute (ICI) report. The number of ETFs has likewise exploded from 119 to 1,411 over the same period.

Some investors are drawn to indexing for its inherent cost efficiency and an attraction to the concept that an investor will not materially underperform a particular benchmark. For example, a manager who is invested only in the iShares S&P 500 cannot materially underperform that benchmark — but of course there is no chance of outperforming either.

Typically, the fund takes a management fee as a percentage of assets on an ongoing basis and there are the usual trading costs for buying or selling on an exchange. But still, the total expenses tend to come out lower than most non-indexed mutual funds because ETFs do not need to pay for big brainpower when the underlying process is to simply replicate an established index.

The massive size and growth of the industry has attracted a few big players. Blackrock purchased industry-leading iShares from Barclays in 2009 and has now become the largest purveyor of ETFs. Not satisfied with merely matching the major benchmarks, iShares continues to launch and maintain specialised funds occupying various niches of the global securities markets. Do you need to index the S&P Europe 350 basket of companies in Australian dollars? iShares has an ETF for you.

The proliferation of ETFs has led to investment managers whose entire platform consists of selecting just the right collection of ETFs for any given client or investment mandate. One advantage of this programme is that such broad diversification makes it unlikely a few bad stock picks will blow up a portfolio. On the other hand, the strategy still requires a skilled manager who can tactically allocate funds to the best sectors, regions, currencies at the right time. In others words, a good top-down macro outlook is required.

One troubling aspect of indexing is that managers who only focus on the big picture tend to lose the discipline and insight that comes with rigorous company-specific analysis. In other words, if the best outcome is mediocrity, perhaps there is no incentive to perform the extra diligent required for outperformance. Often times the extra research and ability to execute is what makes the difference in a firm’s success.

Overall, I am relatively agnostic about ETFs and indexing in general. I use ETFs when I need to get funds in or out of the market quickly and without having to stop and evaluate each potential position while the market is moving. Later, funds can be allocated more directly. In general, I prefer to stay with the larger, more liquid ones that cover major indices. Sector-specific ETF’s are also helpful in covering broad segments of the market where security selection tends not to add much value.

Equity ETFs are fine with me, but I am not a big fan of bond proxies in this space. Offshore investors should be aware that US-based ETFs will typically withhold taxes on up to 30 per cent of the income. On the other hand, some London-traded ETFs provide fixed-income exposure and are not exposed to withholding at the source, but they do tend to be less liquid.

For all ETF trades, I highly recommend using limit orders rather than market orders. On August 24, when markets opened down sharply during an extremely volatile session, some ETFs traded perversely at levels as much as 20 per cent below their underlying value. Anyone selling on that day likely received a bad price. While such major market dislocations are rare it usually pays to be prudent, even it means waiting longer for a good execution.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.