This Powerful Tool Can Give You Instant Diversification

The oft-quoted law of unintended consequences is an intriguing concept.

Let’s say you join a gym to lose weight — and you meet the love of your life there. That’s an unintended consequence.

#-ad_banner-#It works the other way, too. Let’s say you join a gym to lose weight — and you slip in the shower and break a leg.

Both outcomes were unintended consequences. In pursuing your goal to get in shape, you didn’t necessarily go to the gym to meet a potential spouse, and you certainly didn’t join to end up in a cast.

Most of the time, though, we refer to the law of unintended consequences in terms of macro-economic policies and events. Because of the complexities of any large social system, a policy — be it of a monetary nature or a fiscal one — can sometimes lead to an unintended result.

In a 1936 article, sociologist Robert K. Merton identified five reasons a well-intended policy could go wrong — with ignorance and error being the most common ones. In line with his original approach, the law of unintended consequences has come to symbolize almost anything that goes wrong with any policy.

There are too many examples of unintended consequences to count, and many of them arise from the world of technology. The internet, which was basically devised to access information, has resulted in huge changes in the ways we shop, study or date. It’s also responsible for the drastic change in the way most companies do business (email and the cloud are just two examples that come to mind). Even the iPhone — which turned out to be the ultimate game-changer both for Apple (Nasdaq: AAPL) and for us users — was conceived as a simpler, less pervasive device, an iPod that can make calls, as noted in this New York Times article.

Exchanged-Traded Funds: Conceived With Simplicity In Mind
Back in 1993, when the very first exchange-traded fund (ETF) was introduced, the intention was to let everyone invest in the market as a whole. With the creation of the first S&P 500 index fund — the SPDR S&P 500 ETF Trust (NYSE: SPY), also known as “spyder” — the world of investing as we know it changed dramatically.

Originally, ETF investing was possible only for large indices. Following academic research concluding that the best long-term strategy would be to simply follow the market, a market-cap index fund originally served exactly this purpose: creating cheap and well-diversified exposure to the market or to a specific index. Fast forward to 2019 — and the number of ETFs trading on the U.S. exchanges has already exceeded 1,770. That’s more than three times than the number of stocks in the S&P 500 index. Worldwide, there are now more than 5,000 different ETFs.

As a result of the ETF revolution, investors can now buy an exchange-traded fund on pretty much anything we can think of. And while it looks like a good thing for investors, some of the newer crop of ETFs fall very far from what the original ETFs set out to achieve. Many of today’s ETFs don’t create exposure to the entire market and are not cheap. What they can do, however, is allow investors easy access to almost any corner of the market, no matter how narrow or obscure.

Today, there are numerous ETFs designed for replicating market sectors, investing styles, as well as ones designed to employ leverage and double or triple a sector (or market’s) return. But just like anything else in the investing world, it’s not as easy as it might seem.

Choose Wisely
For instance, if you want the best of biotech, you would have to select from as many as 19 different biotech-focused ETFs, from the largest by assets, the iShares Nasdaq Biotechnology ETF (NYSE: IBB), which costs 0.47% in annual fees, to the smallest, the Global X Genomics and Biotechnology ETF (Nasdaq: GNOM), 0.68% in fees.

As always, know what you’re getting into. While IBB is a large-cap heavy ETF, with significant positions in industry leaders such as Amgen (Nasdaq: AMGN), Gilead (Nasdaq: GILD) and Celgene (Nasdaq: CELG), some other small ETFs own the portfolios of genomic, cancer-focused or clinical-stage companies.

Action To Take
ETFs are a good tool if you need to diversify a portfolio or create targeted exposure to a sector. But remember that just because it’s done via the ETF, this won’t make narrow-focused investing less risky. 

Watch out for illiquid ETFs and stay away from the ones that are leveraged (your gains will be magnified, but so will be your losses). Plus, don’t go “short” when your intention is to go long — some ETFs, such as the ProShares UltraPro Short Nasdaq Biotechnology (Nasdaq: ZBIO), are designed to generate positive returns when biotech stocks decline. 

Pick your position as carefully in the ETF universe as you would when you invest in an individual stock. Know your investments, their costs, composition and risks — and watch out for the overlaps with the active portion of your portfolio.

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