I was recently asked this question. The answer is more than just a yes or no answer and the question is long overdue.

Going back in history to when ETFs were created you can see the logic behind the design. It was a way to bring market index funds to the average investor without the overhead cost burden of the mutual fund family. Yes, mutual funds offered index funds but, the ETF added the ability to trade on the market in real time rather than waiting until the close of day price, and they did not carry the burden of the traditional mutual fund overhead. The ETF represented a market index such as U.S. largecap domestic (S&P500), midcap (S&P400), smallcap S&P600 or RUSSELL), international via EAFE, or Japan index, or sectors such as Financial or Materials (SPDR) just to name a few. It was a great way for investors to gain diversification of the representative market efficiently without allocating large amounts of money. It also made parts of the world available to investors that would otherwise be prohibitive in terms of cost or availability such as India or Brazil. Additionally, an investor could tilt or weight parts of markets to achieve a more effective asset allocation. It was such a good idea that it became very popular.

Now, there is an ETF for everything and anything. Creators have gone way beyond the traditional idea of market index representation. The benefits of real time trading and cost efficiency are still there but, the investment coverage has ventured into areas that were traditionally restricted to “sophisticated” investors. Most individual investors are not qualified to evaluate many of the newest ETFs that have appeared and corresponding risks have escalated exponentially.

Some legislators have proposed a blanket restriction on the availability of ETFs so that they would only be available through approved agents. This would be a move in the right direction but, not a good one. The result would be to restrict the useful ETFs, such as the original market index funds, but not necessarily increase the knowledge base on the more sophisticated ETFs. Few “professional” Investors really understand some of the new ETF investments. It reminds me of 10 years ago when many manager-of-manager private equity funds appeared. Only 1 out of 20 advisors actually knew anything about the actual end holdings that made up the private equity funds. It was disgraceful as to the lack of real knowledge people had of the underlying holdings.

Too many ETF creators today are using ETFs as just an extension of the mutual fund business because the ETF topic is hot right now. It is almost as bad as when .com or net funds were being sold without any concern as to the design, history or realistic nature of the investment. ETFs are being recommended because it is “the place to be”, supposedly. I think there should be a second tier of ETFs that cover the non-market index segment. This would cover any ETF that was not a major broad market/sector index and / or included synthetic investment products of any kind. You should be a fiduciary or have an options license before you can put one of the advanced ETFs in a client’s portfolio.

If you are considering adding ETFs to your portfolio that go beyond the broad established market index focus, be careful. Take the time to really understand the investments that are used to create the fund and do not get blinded by the promise of great returns or sophisticated exciting investments.