Following the Herd: Should SRI Investors Join the Stampede into ETFs?

800px-alcelaphus_buselaphus_herd_runningThe National Stock Exchange recently announced that assets invested in ETFs surpassed the $1 trillion mark for the first time in December 2010.  This is more than triple the amount invested in 2005 ($311.3 billion).  And while there were 221 ETFs available to investors in 2005, in December 2010 there were 1,099, a nearly five-fold increase.

While it’s clear both investors and the financial services industry are embracing ETFs as the investment vehicle du jour, the question is should socially responsible investors follow suit?

First, let’s start off with the basics.  What is an ETF?

An Exchange Traded Fund (ETF) is an investment vehicle that holds a basket of securities (stocks, bonds, currencies, or commodities) and trades intraday on an exchange, much like a stock.

Unlike mutual funds, most ETFs are passively managed, meaning they track an index without a manager actively making investment decisions (essentially running on autopilot).

Much like the ETF industry as a whole, there has been an explosion of socially responsible ETFs that have come to market in recent years, many of which are invested exclusively in renewable energy companies.

So what are the benefits to ETF investing?

Low costs – Without a manager buying and selling, expense ratios for ETFs are often significantly lower than actively managed mutual funds.

Intraday trading – Unlike mutual funds, which only price once per day (and can only be bought or redeemed directly through the fund company), ETFs trade on an open exchange and can be bought and sold over the course of the trading day.  There is also no minimum holding period, so an investor could buy and sell the same ETF several times over the course of a day (not recommended).

Tax efficient – Since there is little to no turnover in these portfolios, there are fewer realized capital gains that are passed on to the investor.

Targeted strategies – Some ETFs are set up to track a specific industry or group of companies.  For example, an SRI investor can now invest exclusively in solar or wind power companies through ETFs.

Does this mean SRI investors should be flocking to ETFs?  Not necessarily.

While there are many benefits to ETFs there are also several potential drawbacks:

Passive management – While this helps to keep costs down, a lack of a portfolio manager can potentially hurt an investor, particularly if markets take a turn for the worse or an individual company becomes a bad investment.  With ETFs, so long as the company is part of the index, it remains in the portfolio.

Performance – An ETF will rarely outperform the index it's tracking.  This is because the companies that administer ETFs charge a nominal fee.  Mutual funds may not always beat their benchmark index, but a talented manager often does, and sometimes by a large margin.

Increased risk – Since many SRI ETF strategies are concentrated in a specific sector or industry, the investor is exposed to greater risk, particularly if that sector or industry falls out of favor with investors.

Transaction costs – While ETFs don’t carry sales loads and generally offer lower expense ratios, they do come with transaction costs in the form trading commissions.  So an investor who frequently trades ETFs will have those additional fees to consider.

So what is an SRI investor to do?

While ETFs possess some great features and can make a nice addition to a socially responsible investment portfolio, it’s important to note they also come with risks that should be carefully considered.  As always, if you’re new to investing or are unsure how best to incorporate ETFs into your investment portfolio, contact a professional advisor to help you.

Image credit: Wegmann

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