The Informed Investor
Exchange-traded funds, or “ETFs” for short, are all the rage. From their start in the early 2000s, assets invested in ETFs have recently passed the $4 trillion mark, according to a report by ETF.com. That’s huge for a product that didn’t exist 20 years ago.
While a strong stock market has certainly helped, fixed-income ETFs are experiencing rapid growth as well. And it’s not just individuals buying ETFs. These funds have become popular with institutional investors too.
Why the extreme popularity?
Flight to Passive
Over the past several years, the media has played up the benefits of passive investing. Passive investing is a term for simply trying to match the performance of the overall market instead of trying to beat the market. With passive investing, instead of trying to pick the winners in an index like the S&P 500, you essentially buy the whole index.
Initially, mutual funds were the instrument of choice for passive investing. But mutual funds are not as easy to trade as stocks. You don’t have full price control since the price doesn’t trade freely during market hours. Instead the price is fixed once per day at market close and that is the price you pay to buy or sell that day.
With exchange-traded funds, all that changed. ETFs trade just like stocks, so you can control the price at which you buy and sell those securities.
Suitability for passive index-based investing was one of the initial benefits that helped fuel the rapid rise of ETFs. However, today you can find ETFs for far more than only indexes. For example, you can find an ETF for any of the following purposes:
- Investing in a particular country
- Investing in a particular sector (e.g. energy, tech, health care)
- Investing in a particular style (i.e. value investing or dividend investing)
- Helping you hedge your holdings (or betting an index or sector will fall)
- And much, much more
You’d be surprised by the variety of ETFs out there today. ETFs are often viewed as a product that can help you achieve almost any investing goal.
All the while, ETF companies have promoted the benefits of their products:
- Convenient. Since there are ETFs for many indexes, countries, sectors, etc. you can simply select a corresponding ETF. This saves you from doing the underlying research on all the individual stocks or bonds.
- Diversification. You can get instant diversification by buying an ETF that is comprised of a basket of stocks or bonds.
- Cost-effective. Usually, ETFs have substantially lower fees than similar mutual funds.
- Fast. You can buy and sell them within seconds at any time in the trading day (instead of once per day as is the case with mutual funds).
- Dynamic pricing. The prices change throughout the market day, just like stocks, so you have more control over the price you pay or receive.
- Protection. You have the ability to place specialized types of orders to control your price, such as stop orders and limit orders.
Additionally, ETFs were designed to get around some of the pitfalls of mutual funds:
- Tax issues, you might end up saddled with a tax for capital gains when you didn’t sell any of your holdings.
- Other fees, which are some of the upfront “loads” and “12b1” fees that are part of the mutual fund world.
The availability of ETFs has also driven down management fees, which can provide you immediate and ongoing savings.
But like anything in life, there are usually pros and cons. We have outlined the advantages above. Now let’s examine some of the potential issues with ETFs that many people don’t realize.
Downside: The Spread
When you look up a quote on an ETF, you’ll see there are actually two prices, which are the price that you can buy it at (the “Ask”) and the price you can sell it (the “Bid”). Some large ETFs are liquid so the “spread” (the difference between the two prices) will be very small. But with less liquid ETFs, that may not be the case. As a result, you are essentially losing every time you buy or sell by that amount. Not huge in and of itself, but like all fees, it adds up and eats away at your real return.
How About Individual Stocks and Bonds?
If you’re still with me, you’ve seen the pros and cons to the ETF model. So, where does that leave stocks and bonds?
Let’s take a closer look.
Simple and No Holding Costs
Buying individual stocks and bonds is relatively simple. You research what you want, sometimes pay a commission and buy the stock or bond. Holding costs? There are usually none. No annual fees either. If you receive a dividend (or interest payment on a bond), it is credited to you. You can usually have the dividends automatically reinvested, too.
Ongoing Management Fees
With both ETFs and mutual funds, you pay a manager to oversee the fund. With stocks, there are no management fees. This is an important aspect…these management fees cut into your return every year. Even in years that ETFs lose money, you’ll still have to pay those fees.
With individual stocks and bonds you are responsible for doing your own research. If you have a financial advisor, he or she may be doing that research for you.
If You Have a Financial Advisor
Many people forget that if you have a financial advisor, they will charge you a fee (or commissions). If they are then buying ETFs for your account, the result is multiple layers of management fees. So, if they use ETFs or mutual funds, it is critical that they are using low-cost options.
In many of the big brand name brokerages, advisors are incentivized to sell their proprietary mutual funds and ETFs. Because of the brand names, these usually carry a premium. Do you get what you pay for? Unfortunately, all that does is generate more annual fees for you and it does not necessarily equate to better results.
So, it’s critical that you carefully monitor your advisor to make sure they always choose low-cost investments for you.
Which Strategy is Best for You?
As you can see, there is no perfect answer. It will depend on where you’re starting from, your personal tax situation and your ability to tolerate risk, along with other factors. What’s important to remember is that there is no magic bullet in investing. And things can be very, very confusing for individual investors since the industry continually implements and promotes new products and services.
That’s where having an experienced, fee-only fiduciary advisor on your side can help you wisely navigate the increasingly complex investment landscape. A quality advisor can help you avoid costly financial mistakes, stay on track to achieve your goals and help protect your assets during volatile times.
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