Qubes. StreetTracks. HOLDRs. Names of popular rock groups? Not even close. They’re all investments called exchange-traded funds (ETFs) and many people use them to build a diversified portfolio. Maybe you should, too — if you understand the risk/reward trade-offs.

An ETF is a basket of securities, shares of which are sold on an exchange, such as the American Stock Exchange. They combine features and potential benefits of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that’s assembled by professional managers.

Types of ETFs

There are a number of ETFs, each with a different investment focus. Following are some common types of ETFs.

• Diamonds follow the 30 large-cap companies that make up the Dow Jones Industrial Average.

• Standard & Poor’s Depositary Receipts (Spiders) mirror the S&P 500, an index of 500 of the largest companies in the United States. They also track select sectors of the S&P 500.

• iShares hold baskets of stocks in specific regions of the world, select countries, or sectors, or follow U.S. corporate or government bond securities.¹

• Qubes track the 100 largest businesses of the technology-driven Nasdaq Composite Index.

• StreetTracks replicate various indexes focused on sectors, countries, or investment style.¹

• Holding Company Depositary Receipts (HOLDRs) are ETFs with a twist. They usually focus on narrow, emerging sectors — companies building the Internet infrastructure, for example — and their baskets hold only about 20 stocks to begin with. Stocks will never be added, and over time a HOLDR’s basket can become even more concentrated, as stocks that are lost due to mergers aren’t replaced. HOLDRs also differ from most ETFs in that they only trade in lots of 100 shares and shareholders can exchange their shares for the underlying stocks at any time by paying a fee.

Investors should note that because many HOLDRs are narrowly focused, they can be more volatile than other types of ETFs. Also, HOLDR investors will receive annual reports and other investment-related information for each of the 20 stocks in their HOLDR basket. On the other hand, they’ll only pay one brokerage commission instead of 20.

Different Structures

Originally ETFs were organized as unit investment trusts (UITs). In a UIT, an investment company buys a fixed portfolio of securities and then sells shares of that portfolio to investors. This type of structure results in dividends being held in an interest-bearing account, which are deposited into the ETF once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF because the dividends are held as cash instead of being invested. Spiders, Diamonds, and Qubes are all organized as unit investment trusts.

Other ETFs, such as iShares, Select Sector Spiders, and StreetTracks, are structured as open-end funds. This arrangement follows the typical mutual fund structure in that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately.

Evaluating ETFs

These investments offer a number of potential advantages, including:

Tax efficiency – ETFs may be more tax efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund’s objectives. Selling shares may create taxable gains for the fund’s shareholders. Because ETFs are like stocks, redemptions aren’t an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.

Low expenses — ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.

Flexible trading — Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.

Can be sold short and bought on margin — Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin. Traditional mutual funds do not allow shorting of stock or margin trading.

No minimum investment — Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.

Diversfication — An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock — an ETF may own shares of many different technology companies.

Of course, as with all investments, ETFs may involve risks and other potential drawbacks. Consider these factors before investing:

The trading flexibility of ETFs may encourage frequent trading. That could lead to the possibility of mistiming the market (moving stocks in and out of the market at the wrong times).

Brokerage commissions are incurred. For this reason ETFs may be better suited for a buy-and-hold investor or someone who is buying a large number of shares at one time, rather than for an investor who uses a systematic investment program.

There may be capital gain distributions. At times some ETFs have distributed taxable capital gains usually because the managers have needed to buy or sell stocks to match their underlying benchmarks. Additionally, government bond ETFs are subject to federal income tax.

You should carefully consider the risks of different ETFs. Many sector ETFs, for instance, will tend to be more volatile than an ETF that tracks the broader market. Check with a financial professional to be sure that you understand the risks and have the most up-to-date information before investing in an ETF.

Points to Remember

1. Exchange-traded funds (ETFs) offer potential benefits and risks of both mutual funds, stocks, or bonds.

2. ETFs have different types of structures: Some are set up as unit investment trusts. Others are structured like open-end mutual funds, and dividends are continually reinvested.

3. Advantages of ETFs include potential tax efficiency, low expense ratios, flexible trading, and portfolio diversification.

4. Disadvantages of ETFs include occasional distribution of capital gains, brokerage commissions, and the potential for frequent trading, which could lead to mistiming the market.

5. ETFs may be better for a lump-sum investor with a long time horizon than someone who trades frequently and/or invests at regular intervals.

Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Sector funds are subject to increased volatility due to their limited diversification compared with other stock funds.

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© 2011 McGraw-Hill Financial Communications. All rights reserved.

April 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Martin V. Higgins, CFP, CLU, AEP , a local member of FPA.

Stocks, bonds, and cash are fundamental components of an investment portfolio. However, many other investments can be used to try to spice up returns or reduce overall portfolio risk. Socalled alternative assets have become popular in recent years as a way to provide greater diversification.

What is an alternative asset?

The term “alternative asset” is highly flexible; it can mean almost anything whose investment performance is not correlated with that of stocks and bonds. It may include physical assets, such as precious metals, real estate, or commodities. In some cases, geographic regions, such as emerging global markets, are considered alternative assets. Complex or novel investing methods also qualify. For example, hedge funds use techniques that are off-limits for most mutual funds, while private
equity investments rely on skill in selecting and managing specific businesses. Finally, collectibles are included because the value of your investment depends on the unique properties of a specific item as well as general interest in that type of collectible.

Each alternative asset type involves its own unique risks and may not be suitable for all investors. Because of the complexities of these various markets, you would do well to seek expert guidance if you want to include alternative assets in a portfolio.

Hedge funds

Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are considered an alternative asset class because of their unique, proprietary investing strategies, which may include pairs trading, long-short strategies, and use of leverage and derivatives. Participation in hedge funds is typically limited to “accredited investors,” who must meet SEC-mandated high levels of net worth and ongoing income (individual funds also usually require very high minimum investments).

Private equity/venture capital

Like stock shares, private equity and venture capital represent an ownership interest in one or more companies. However, unlike stocks, private equity investments are not listed or traded on a public market or exchange, and private equity firms often are involved directly with management of the businesses in which they invest.

Private equity often requires a long-term focus. Investments may take years to produce any meaningful cash flow (if indeed they ever do); many funds have 10-year time horizons. Like hedge funds, private equity also typically requires a large investment and is available only to investors who meet high SEC net worth and income requirements.

Real estate

You may make either direct or indirect investments in buildings–either commercial or residential–and/ or land. Direct investment involves the purchase, improvement, and/or rental of property; indirect investments are made through an entity that invests in property, such as a real estate investment trust (REIT). Real estate not only has a relatively low correlation with the behavior of the stock market, but also is often viewed as a hedge against inflation.

Precious metals

Investors have traditionally purchased precious metals because they believe that gold, silver, and platinum provide security in times of economic and social upheaval. Gold, for instance, has historically been seen as an alternative to paper currency and therefore
may help hedge against inflation and currency fluctuations. As a result, gold prices often rise when investors are worried that the dollar is losing value, though prices can fall just as quickly. There are many ways to invest in precious metals. In addition to buying bullion or coins, you can invest in futures, shares of mining companies, sector funds, and exchange-traded funds (ETFs).

Natural resources

Direct investments in natural resources, such as timber, oil, or natural gas, can be done through limited partnerships that provide income from the resources produced. In some cases, such as timber, the resource replenishes itself; in other cases, such as oil or natural gas, it may be depleted over time. Timberland also may be converted for use as a real estate development.

Commodities and financial futures

Commodities are physical substances that are fundamental to creating other products or to commerce generally. Commodities are basically indistinguishable from one another. Examples include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals such as copper and zinc.

Commodities are typically traded through futures contracts, which promise delivery on a certain date at a specified price. Futures contracts also are available for financial instruments, such as a security, a stock index, or a currency. Though the futures market was created to facilitate trading among companies that produce, own, or use commodities in their businesses, futures contracts also are bought and sold as investments in themselves, and some mutual funds and ETFs are based on futures indexes.

Futures allow an investor to leverage a relatively small amount of capital. However, they are highly speculative, and that leverage also magnifies the potential loss if the market does not behave as expected.

Art, antiques, gems, and collectibles

Some investors are drawn to these because art, antiques, gems, and other collectibles may retain their value or even appreciate as inflation rises. However, those values can be unpredictable because they are affected by supply and demand, economic conditions, and the quality of an individual piece or collection.

Why invest in alternative asset classes?

Part of sound portfolio management is diversifying investments so that if one type of investment is performing poorly, another may be doing well. As previously indicated, returns on some alternative investments are based on factors unique to a specific investment. Also, the asset class as a whole may behave differently from stocks or bonds.

An alternative asset’s lack of correlation with other types of investments gives it potential to increase or stabilize a portfolio’s return. As a result, alternative assets can complement more traditional asset classes and provide an additional layer of diversification for money that is not part of your core portfolio, though diversification cannot guarantee a profit or ensure against a loss.

Tradeoffs you need to understand

Alternative assets can be less liquid than stock or bonds. Depending on the investment, there may be restrictions on when you can sell, and you may or may not be able to find a buyer. Performance, values, and risks may be difficult to research and assess accurately. Also, you may not be eligible for direct investment in hedge funds or private equity. The unique properties of alternative asset classes also mean that they can involve a high degree of risk. Because some are subject to less regulation than other investments, there may be fewer constraints to prevent potential manipulation or to limit risk from highly concentrated positions in a single investment. Finally, hard assets, such as gold bullion, may involve special concerns, such as storage and insurance, while natural resources and commodities can suffer from unusual weather or natural disasters. A financial professional can advise you on whether alternative assets have a role in your portfolio, and which types might be appropriate for you.

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