Do your homework with ETFs

NEW YORK -- Some of the newest exchange-traded funds seem to resemble their predecessors about as much as a svelte Toyota Camry looks like a lumbering Model T.

But as with those dissimilar vehicles, many types of ETFs are capable of taking investors where they need to go. Investors just need to find something they are comfortable with and recognize whether an ETF makes sense for a chunk of their portfolio or perhaps only a thin slice of it.

An ETF is a security that tracks an underlying benchmark much like an index mutual fund but trades like a stock on an exchange. It can therefore be bought and sold during the trading day and can boast low expenses.

Their popularity has meant about 155 ETFs have been introduced so far this year, compared with 159 all of last year. Many of these newer ETFs are taking on smaller slices of the market, not simply big, broadly diversified indexes. This month, XShares Advisors introduced the HealthShares Orthopedic Repair ETF tracks companies that focus on that segment of the health care sector. Late last month saw the arrival of the Claymore/Clear Global Vaccine Index ETF, which covers companies that develop vaccines.

"ETF providers have rolled out more and more narrowly focused ETFs," said Sonya Morris, an analyst at investment research provider Morningstar Inc. "As some of the big players have covered most of the equity bases, some of the smaller players have had to get even more narrow to find a niche that hasn't already been covered."

The narrow parameters that some ETFs now embrace can mean investors have uneven returns.

"The very narrowly focused ones might attract performance chasers," Morris said, noting that by the time investors are drawn to strong results, the party is often over.

"The chance of that continuing indefinitely is really impossible," she said of outsize returns. "If you're going to use these narrowly focused ETFs, it's imperative that you do your homework. Really the best way to approach the ETF market is with a contrarian eye and take a look at those sectors that haven't performed as well and are possibly loaded with cheap stocks."

While she doesn't discount all tightly focused ETFs, Morris said investors should consider whether, as in the case of an ETF focused on treatments for a single type of medical problem, the success of one stock could imperil the viability of an entire sector. If a cancer treatment developer, for example, developed a successful product, rival companies could be sidelined.

"If that one firm is successful, does that mean that there's no need for the market anymore? Does that really put the other stocks in the ETF behind the eight ball?"

But if investors are bullish on an industry's prospects, sector ETFs help mitigate the attendant risks of investing in one or two stocks. Of course, the broader base can also dampen returns.

In May, Van Eck Global introduced the Van Eck Market Vectors Global Alternative Energy ETF.

"With wind or solar or biofuels, it's hard to pick one stock or two stocks to buy to capture the entire theme," said Adam Phillips, director of ETF sales at Van Eck. "There is a place for these type of ETFs. They're fantastic alternatives to single-stock selection."

Market watchers said, however, that the diversification ETFs can bring doesn't excuse investors from knowing where their money is going.

"Investors should be cautious in these areas unless they have great expertise," said Tom Roseen, an analyst at fund-tracker Lipper Inc. "Some of the slicing -- for the average retail investors -- has become much too narrow."

The tighter focus of some ETFs could simply signal a maturing market. A number of new ETFs are also focusing on asset classes not as previously not as well served, such as bonds, commodities and currencies.

Rydex Investments, for example, offers eight currency ETFs.

"We just see this is as sort of an evolution that is necessary," said Tim Meyer, business manager for ETFs at Rydex. "Obviously these are smaller pieces of any portfolio. They may be extremely volatile but over all they can help diversify (a portfolio)."

"We would never recommend for investors putting more than between 3 to 4 percent of their overall portfolio in foreign currencies."

In making decisions about where to put their money, those interested in ETFs would do well to seek the advice of a professional.

"Any investment product can be misused," Phillips noted. "Investors and their financial advisers need to be aware of where within the portfolio construction the product is going to be used. If used properly, I think they're wonderful tools for investors."