Investing in ETFs in Volatile Times

11/09/2011 11:54 am ET | Updated Jan 09, 2012

My nephew, a new college graduate and not familiar with many investment possibilities, discussed with me how he could invest savings. The investment community continues to offer innovative ways to diversify and to create value. Most people are familiar with mutual funds, a basket of different equities in which you can trade easily. Less people are comfortable with Exchange Traded Funds (ETFs). By owning an ETF, you can achieve diversification of an index fund and have the ability to sell short or buy on margin. You can also trade it all day long rather than at the end of the day for mutual funds.

The biggest advantage of ETFs is that the expense ratios are lower than those of the average mutual fund. The most widely known ETF is the SPDR (pronounced Spider) which tracks the S&P 500 index. I was never a fan of ETFs when only passive indexes were available. The problem with a passive index fund is that it doesn't protect the assets in a down market. In other words, if the top 500 companies included in the Standards & Poor's index have an average 10 percent decline in their share prices, so will the SPDR ETF. With volatility here to stay, it is more important to achieve diversification and to know what equities you are invested in. This would suggest an actively managed ETF tailored to the markets you believe will have companies with good earnings results would be a good investment. Such ETFs now exist and are quite interesting.

I recently researched the ETF industry and read the active manager WisdomTree's business overview to share with my readers. According to WisdomTree's report, ETFs began in 1995 and reached $100 billion of assets under management in 2002. By June of 2011, assets have grown by a multiple of ten to over $1 trillion of assets under management (AUM). There are roughly 1000 ETFs in the US markets and more are added every day. ETFs compete against long-term mutual funds and represent about 10 percent market share of this $11 trillion market. In fact, the pivotal change in this investment shift occurred in 2008. The ETF industry achieved net inflows while mutual funds experienced net outflows. The ETF growth trend is continuing. So, who controls these ETF families of funds?

Of the top ten families of funds, BlackRock with their iShares brand leads the list with $476 billion AUM. State Street is the second largest with the brand of SPDRs with $259 billion AUM. Vanguard is a mutual company which brands their ETFs under their own name and is the third largest sponsor with $175 billion AUM. This company was founded by Jack Bogle who was interviewed at the end of this September by Yahoo's Breakout show. He discusses ETFs and states:

"The game is rigged," says Jack Bogle, the octogenarian founder of The Vanguard Group. "It is too convoluted. It is too complex. You shouldn't be playing the game. You don't need to play the game."

"If you own the stock market for a lifetime, you get those returns. Playing games in the stock market, over every day of that time, is playing the stock market. The stock market game is rigged, the business of investing is not rigged," says Bogle.

His reasoning is simple. The use of capital by companies to "develop new products, efficiencies, innovations, productivity, the improvement of consumer goods and services at lower and lower prices" is all very real and ultimately validated through earnings.

So, if Vanguard's founder, former CEO and current President of Vanguard's Bogle Financial Markets Research Center doesn't believe in the products, it makes one question why you should consider the investment class. (Note: Vanguard spokesperson John Woerth responded that Vanguard very much believes in ETFs as a low-cost way for investors and financial advisors (on behalf of their clients) to obtain broadly diversified exposure to the world's stock and bond markets). So, there is no shortcut to understanding how companies create earnings and use their capital. My nephew may want to take a financial course before plunging into the world of investments.