ETFs are a cheap way to play the market
Exchange-traded funds earn a spot in more investors’ portfolios
ETFs are all the rage for investors these days. According to the most recent Investment Company Fact Book, there were nearly $2 trillion in ETF assets at the end of 2014 — up from just $151 billion at the end of 2003.
But what the heck are ETFs exactly, and are they right for you?
ETF stands for “exchangetraded fund,” and like the name implies, these are investments that trade throughout the day on an exchange. This is a big difference from traditional mutual funds, says Herb White, a certified financial planner and president of Life Certain Wealth Strategies in Denver.
“Both of them are a basket of securities, and in both cases they are a way for a person to diversify their holdings,” White says. “The major difference between the two is that the mutual fund is only priced at the close of the trading day, and an ETF does trade just like a stock through the day.”
SIMILARITIES TO STOCKS
In other words, an ETF is a fund that trades more like a stock — which sounds like a minor distinction but it’s an important one.
For instance, you can’t just invest a fixed sum like you can with mutual funds. ETFs don’t have fractional shares, so you have to buy whole shares at market price. So if an ETF trades for $51.50 per share and you have $100, you can only buy one share.
While this is a bit more complex for investors, the format allows ETFs to be much more “liquid” than mutual funds — meaning a very active market of buyers and sellers, and thus less friction and cost added in when an investor buys or sells.
ETFs are also cheaper, in large part, because these investments are commonly tied to an index — that is, a fixed list of investments such as the 30 stocks in the Dow Jones industrial average or the constituents of the S&P 500.
“In many mutual funds, you’re paying for someone to actively manage it. You’re paying for their time, their research. But an index fund is just a group of pooled stocks, and you can have a computer program manage things,” says Megan Petruska, director of portfolio research and advisory at McMahon Financial Advisors in Pittsburgh.
In addition to these lower embedded expenses, ETFs also don’t charge additional “loads” that some mutual funds do, Petruska says. If applicable, these mutual fund commissions, typically 5.75%, eat into your nest egg.
There are also structural and regulatory factors that make ETFs cheaper to run, savings that institutions can “pass on to the investor,” says Dave Nadig, director of exchange-traded funds at financial information provider FactSet Research Systems.
And best of all, the downward momentum in the cost of owning ETFs is continuing, he adds.
Nadig gives the biggest example of the popular SPDR S&P 500 ETF, a passive fund benchmarked to the S&P 500 index that launched in the 1990s and charged investors just 0.16% annually, or $16 each year on every $10,000 invested. Now, it charges about 0.10% or $10 annually on every $10,000.
“The prices are only going one direction over time, and that’s down,” Nadig says.
ARE ETFS RIGHT FOR YOU?
Given the very low costs associated with ETFs, they are the ideal investment for beginning investors who either don’t have a lot of experience or have a lot of cash to put into the market.
“For an investor that’s really not going to immerse themselves in understanding the intricacies of these funds, just look at a simple S&P fund or something like that with a simple buy-and-hold strategy,” White says.
Of course, the cost savings only works if you’re making infrequent transactions or using a platform that allows you to purchase ETFs without additional trading fees. For instance, if you’re using a broker that charges $10 for each transaction, but you’re only investing $100 each month, you’re actually taking an additional 10% hit with every purchase.
“If you were making systematic purchases, taking money out of each paycheck every week and buying ETFs that way, when you take into consideration the fact of a commission to purchase that ETF, that may not be as cost-effective since it counteracts the otherwise low cost of ETFs,” White says.
It’s important to remember that while novice investors can have confidence in a buy-andhold strategy that focuses on ETFs holding big-name U.S. stocks, there are plenty more aggressive ETFs out there that can expose your portfolio to big risks.
That means it’s still on investors to do their homework and pick exchange-traded funds that match their overall investment strategy and risk profile.
“Like any investment, you really need to understand what you’re investing in. Just because something is an ETF doesn’t make it perfect,” Nadig says. “There are now almost 2,000 ETFs trading in the United States, and somewhere out there is the worst one. There are plenty of opportunities for investors to make mistakes.”
The cost of owning ETFs is low, and “the prices are only going one direction over time, and that’s down.”
Dave Nadig, FactSet Research Systems