As I noted in a post from November, my husband and I are debating whether to go with a new financial planner. One that we recently contacted indicated in his marketing materials that he uses ETFs, or exchange-traded funds, with his clients. While I’ve heard of ETFs, I wasn’t exactly sure just how they worked, or if they would be a good investment choice for us.
So, I did some research. Here’s what I found out: ETFs are securities that track an index, a commodity or a basket of assets, much like an index fund, according to Investopedia. Similarly, ETFs offer the ability to diversify your investments. Unlike an index fund, however, ETFs trade throughout the day on an exchange.
In addition, with ETFs, you can buy on margin or sell short. Buying on margin means that you make only a down payment for the purchase, and then use the securities themselves as collateral for the unpaid amount. Short selling is a way to (hopefully) profit on what you think will be a drop in the price of a security. You do this by borrowing the securities, then turning around and sell them, with the idea of buying them back later, at the (expected) lower cost. Then, you can pocket the difference between what you earned on the sale and what you had to pay to buy back the securities. In any case, both are risky strategies, and not something that I plan to do with the money we’re saving for retirement.
However, I was more interested in the claim made by some that ETFs usually have lower expense ratios than mutual funds. The average expense ratio for an index mutual fund is 1.06 percent, versus .4 percent for ETFs, according to “A Comparison of Mutual Funds and Exchange Traded Funds,” by Jason Johnson, associate professor with Texas A&M.
In part, the difference is due to the lower cost structure of ETFs. Because transactions occur directly between investors, without a fund company sitting in the middle, ETFs don’t have to employ armies of call center employees and account managers, Morningstar notes.
However, this claim isn’t as absolute as it first appears, as the fees for some index funds are competitive with ETFs. For instance, fees charged by the 650-some ETFs funds listed by Morningstar in 2008 ranged from .07 to 1.25 percent. The lowest mutual funds came in at .05, although the most expensive charged an obscene 10-plus percent, Investopedia reports.
In addition, most ETF investors pay brokerage commissions when they buy or sell their holdings. While we would be buy-and-hold investors, these fees would add up, given that we’d be purchasing on a regular basis – probably monthly.
On the other hand, Professor Johnson identifies several other advantages of ETFs that merit our consideration. One is an enhanced ability to keep tabs on the allocation of assets. That’s because ETFs trade on one of the three major exhanges. So, we could have a group of ETFs – say, several each or different types of stocks and bonds – and see all of them in one shot. Unless we were to buy mutual funds that are all from the same company, it gets difficult to get a single view of our mutual fund holdings. And, ETFs have a slight edge in transparency, since their holding are updated daily. In contrast, mutual funds are required to state their holdings only twice a year, although some do it more frequently.
In the end, I think we’ll stick with no- or low-load index funds for our ongoing retirement savings; the commissions we’d pay to invest regularly in ETFs would outstrip any reduction in fund expenses. However, if we, for some reason, come into a lump sum that we’d like to invest, we give more consideration to an ETF.
How about you? Do you prefer mutual funds or ETFs? Or, do you invest in both, depending on the type of investment you’re making?