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Editor's Letter: ETFs, Use Them Wisely

What happens if everyone buys into index funds? For years Jack Bogle and other proponents of index funds have brushed aside that question.

What happens if everyone buys into index funds? For years Jack Bogle and other proponents of index funds have brushed aside that question. But lately the amount of assets in index funds may have reached a tipping point. About 25 percent of institutional and retail assets are now in index funds, and many active funds are actually closet indexers. This big concentration in the S&P 500 and other indexes is causing many distortions in the markets. Stocks spike whenever they enter the S&P 500. Because market-weighted index funds concentrate investments in a few stocks, stock markets have become more volatile and prone to bubbles. With more investors trading broad ETFs, most stocks tend to move in lockstep with the benchmarks. That makes it harder to diversify portfolios. In an era when index funds dominate, there may be good reasons to go against the crowd and try some top actively managed funds.

No, I am not saying one shouldn't use index funds, especially in efficient markets where the goal is to get beta. But one must be careful. ETFs still continue to grow and there are 866 ETFs worth about $741 billion from 30 providers, according to BlackRock research, which is number one in the ETF game, having bought Barclays Global Investors' iShares cache. Year-to-date ETFs increased by 12 percent with 117 new ETFs launched; there are many more in registration. Year-to-date 23 ETFs were delisted. And therein lies the point: There are scores of small ETFs that don't trade much. As Stan Luxenberg points out this month on page 59, small, esoteric ETFs can hurt when they liquidate — a client can lose 3 percent or more. According to Morningstar, thinly traded ETFs can cost even more to investors when bid and ask spreads and other expenses are added up. Please turn to Stan's article for more on this topic.

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