ETFs: Which funds are the right fit for you?
If stock-picking prowess isn’t in your genes, investing in a broad basket of equities through low-cost exchangetraded funds is a good way to go.
Exchange-traded funds, or ETFs, are funds that track stock indexes like the Standard & Poor’s 500. They can be bought and sold like shares during the trading day. Traditional mutual funds and index funds, by contrast, are priced just once a day at the close of trading.
ETFs, thanks to low fees, friendly tax treatment, diversification and the growing number that can be purchased commission-free online, have exploded in popularity.
There were 1,925 ETFs trading in the U.S. at the end of July, nearly triple from the end of
2008, according to ETFGI, a London-based firm that tracks the ETF business. During that same period, money invested in ETFs grew to $3.5 trillion, up from about $500 billion.
“An investor can use an ETF to bet on the future of a particular country, sector or market theme,” says Ben Johnson, director of global ETF research at Morningstar in Chicago.
Low costs are a big reason investors are flocking to ETFs. The average expense ratio in
2017 for index-based stock ETFs was 0.21 percent, according to the Investment Company Institute. That’s just $21 in annual fees for a $10,000 investment. There are S&P 500 ETFs offered by Vanguard and BlackRock’s iShares that charge just
0.04 percent.
By contrast, the average fee for actively managed stock funds run by portfolio managers was 0.78 percent, and 0.09 percent for equity index mutual funds.
ETFs also are more tax efficient than traditional mutual funds. ETF investors only pay taxes when they sell and report a profit. Not only do mutual fund investors pay similar capital gains taxes on their own trades, they also are subject to taxes on the capital gains and dividends that the fund is subject to via its own trading activities and which it distributes to all shareholders.
There’s now an ETF that fits the needs of pretty much all investors – for people who want cheap exposure to the market, as well as those who want to pick ETFs that focus on a sliver of it.
But more exotic ETFs, and ones that target virtually every sub-segment of the market, also are available.
There are ETFs that focus on robotic stocks, blockchain technology companies, large Chinese equities, as well as less-risky U.S. stocks with “low volatility.”
The many choices, however, can mean more complexity and increase the potential for portfolio missteps.
There’s always a risk that an investor can get too overconfident and chase hot-performing ETFs. Or try to time the market. Or build a portfolio filled with a slew of ETFs that own many of the same stocks, which could cause them to accumulate too big a helping of, say, high-flying tech stocks.
The more active an approach to ETFs you take, the more you open yourself up to the types of risks normally associated with trying to pick winning stocks, says Todd Rosenbluth, director of ETF and mutual fund research at CFRA, a New York-based investment firm.
“The more decisions you make, the greater likelihood those decisions will be wrong, the same way it would be with individual stocks,” Rosenbluth says.
Data show it’s tough for fund managers to post better returns than the benchmarks they’re measured against. In the 12 months ended in June, for example, only 36 percent of active U.S. stock fund managers topped their benchmarks, according to Morningstar.
ETFs allow investors to buy and sell during the day, which allows them the flexibility to, say, lower their exposure to stocks in a market that is heading sharply lower. A fund investor that puts in a sell order on a given day will get out at the final closing price of the day, which could be much lower.
So what type of ETF strategy is right for you?
Hands-off investor
Someone who wants to invest in the stock market, but not worry about trying to produce market-beating returns or keep tabs on specific investments, is best served by using ETFs that provide broad market exposure.
“It’s incredibly simple,” says Johnson. “Most investors can build a very solid, diversified portfolio using as few as two or three ETFs.”
A lineup could include the total U.S. stock market, a broad international stock offering and a U.S. bond ETF, Rosenbluth says.
This portfolio should require little trading or tinkering, as its goal is to simply match the returns the broad indexes deliver at the lowest cost possible. Less trading in and out of the market will minimize market-timing mistakes and taxable trades, says Dave Nadig, managing director at ETF.com, which provides investors with ETF news and analysis.
The major benefits of an index ETF fund, however, become less relevant in 401(k) plans, as savings and gains are already growing tax-deferred, and most plans offer index funds that also come with rockbottom fees, Nadig says.
Sophisticated trader
Investors who want to try to beat the stock market by singling out ETFs that target smaller slivers of it can go beyond core holdings like the S&P 500. If you think the outlook for the emerging robotics business or blockchain technology is bright, you might consider ETFs that invest in these areas, Morningstar’s Johnson says.
But a more active approach to ETF investing also can be more risky, as chasing a hot ETF is no different than chasing a hot stock.
“What you’re doing is making a forecast and trying to outsmart the market,” says Peter Lazaroff, chief investment officer of Plancorp, an advisory firm in St. Louis, Missouri.