Chapter 5
Exchange-Traded Funds and Other Fund Lookalikes
In This Chapter
Making sense of the hoopla of exchange-traded funds
Understanding unit investment trusts
Creating your own customized funds
The hallmarks of the investment and economic system are constant change, innovation, and choice. Index mutual funds, which track a particular market index (see Chapter 10) and the best of which feature low costs, have been around for decades.
Exchange-traded funds (ETFs) represent a twist on index funds — ETFs trade like stocks do and offer some potential advantages over funds. However, some cheerleaders pitching ETFs gloss over drawbacks to ETFs and fail to disclose their agenda in promoting ETFs.
Some other fund wannabes compete for your investment dollars too. This chapter offers the straight scoop on these alternatives.
Understanding Exchange-Traded Funds
For many years after their introduction in the 1970s, index mutual funds got little respect and money. Various pundits and those folks with a vested financial interest in protecting the status quo, such as firms charging high fees for money management, heaped criticism on index funds. (As I explain in Chapter 13, index funds replicate and track the performance of a particular market index, such as the Standard & Poor’s 500 index of 500 large company U.S. stocks.) Critics argued that index funds would produce sub-par returns. Investors who’ve used index funds have been quite happy to experience their funds typically outperforming about 70 percent of the actively managed funds over extended time periods.
In recent years, increasing numbers of financial firms have developed exchange-traded funds (ETFs). Most ETFs are, essentially, index funds with one major difference: They trade like stocks on a stock exchange. The first ETF was created and traded on the American Stock Exchange in 1993 and was known as a Spider. (It tracked the Standard & Poor’s 500 index.) Now hundreds of ETFs trade comprising about $700 billion — a large sum indeed — but that’s less than 7 percent of the total invested in mutual funds.
Before you decide to invest in ETFs, take a moment to read this section. It explains the advantages and disadvantages of investing in ETFs and helps you wade through the many ETFs to find the best one for you.
Understanding ETF advantages
Like index funds, the promise of ETFs is low management fees. I say promise because when evaluating ETFs, you must remember that the companies creating and selling ETFs, which are mostly large Wall Street investment firms, are doing it to make a nice profit for their firm. Although the best index funds charge annual fees of less than 0.2 percent, the vast majority of ETFs actually charge fees much greater than that.
Take a look at Table 5-1 for an analysis that I recently conducted of ETF expense ratios.
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Table 5-1 An Analysis of ETF Expense Ratios |
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|
Expense Ratio |
Percentage of ETFs |
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0.60% and higher |
47% |
|
0.50% to 0.59% |
14% |
|
0.40% to 0.49% |
12% |
|
0.30% to 0.39% |
7% |
|
0.25% to 0.29% |
7% |
|
0.20% to 0.24% |
6% |
|
0.15% to 0.19% |
2% |
|
0.10% to 0.14% |
4% |
|
0.07% to 0.09% |
1% |
The vast majority of ETFs have expense ratios far higher than the best index funds. I compare the best index funds with the best ETFs (which do have low expense ratios) in the section, “Identifying the best ETFs,” later in this chapter.
In addition to possible slightly lower expenses, the best ETFs have one possible additional advantage over traditional index funds: Because ETFs may not be forced to redeem shares to cash and recognize taxable gains (which can happen with an index fund), they may be tax friendlier for non-retirement account investors. (Note: ETFs do have to sometimes sell and buy new holdings as adjustments are made to the underlying index that an ETF tracks.)
If you can’t meet the minimum investment amounts for index funds (which are typically several thousand dollars), you face no minimums when buying an ETF. However, you must factor in the brokerage costs to buy and sell ETF shares through your favorite brokerage firm, and be sure that those fees don’t greatly boost your costs. For example, if you pay a $10 transaction fee through an online broker to buy $1,000 worth of an ETF, $10 may not sound like a lot but it represents 1.0 percent of your investment and wipes out the supposed cost advantage of investing in an ETF. Because of the brokerage costs, ETFs aren’t a good vehicle for investors who seek to make regular monthly investments.
Eyeing ETF drawbacks
Meanwhile, some of the drawbacks to ETFs include the following:
Three-day settlement waiting period: A possible disadvantage with ETFs is that like stocks, you have a three-day settlement process when selling shares. So, for example, if you sell shares of an ETF on Monday, you won’t have the proceeds to invest into a regular mutual fund until Thursday. (This delay wouldn’t be a problem if you’re going back into another ETF or buying a stock — because a purchase order placed on Monday wouldn’t settle until Thursday.) If you’re out of the market for several days, the market price can move significantly higher, wiping out any supposed savings from a low-expense ratio.
Potential fees for dividend and capital gain reinvestments: With a traditional mutual fund you can without cost reinvest dividend and capital gains distributions into more shares of the fund. However, with an ETF, you may have to pay for this service, or it may not be available through the broker that you use.
Disproportionate amount of stocks: One problem with a number of the indexes that ETFs track (and with some index funds) is that certain stocks make up a disproportionately large share of the index. For example, I don’t care for the Standard & Poor’s 500 index because each of the 500 stocks’ composition in the index is driven by each stock’s portion of total market value. Check out Table 5-2 that shows the composition of the index at the end of 1999. This list mostly represented a who’s who of many overpriced technology stocks that subsequently got clobbered in the early 2000s bear market.
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Table 5-2 The Companies of the Standard & Poor’s 500 Index at the End of 1999 |
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Stock |
Rank in Index |
Market Value |
Percent of Index |
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Microsoft Corp |
1 |
604,078 |
4.92% |
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General Electric |
2 |
507,734 |
4.14% |
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Cisco Systems |
3 |
366,481 |
2.99% |
|
Wal-Mart Stores |
4 |
307,843 |
2.51% |
|
Exxon Mobil |
5 |
278,218 |
2.27% |
|
Intel Corp |
6 |
274,998 |
2.24% |
|
Lucent Technologies |
7 |
234,982 |
1.91% |
|
IBM |
8 |
194,447 |
1.58% |
|
Citigroup Inc |
9 |
187,734 |
1.53% |
|
America Online |
10 |
169,606 |
1.38% |
Invested segments too narrow: Many of the newer ETFs coming out invest in narrow segments, such as one specific industry or one foreign country. As with sector mutual funds (see Chapter 13), such funds undermine the diversification value of fund investing and tend to have relatively high fees. Morningstar, an investment research company, says, “. . . ETFs offer new opportunities to sap returns by racking up transaction costs and/or chasing short-term trends.”
Excessive risks and costs with leverage: In recent years, ETF issuers have come out with increasingly risky and costly ETFs. One particular class of ETFs I especially dislike are so-called leveraged ETFs. What these ETFs purport to do is magnify the move of a particular index — for example, the Standard & Poors 500 stock index — by double or triple. So, a double-leveraged S&P 500 ETF is supposed to increase by 10 percent for every 5 percent increase in the S&P 500 index. Inverse leveraged ETFs are supposed to move in the opposite direction of a given index. So, for example, a double-leveraged inverse S&P 500 ETF is supposed to increase by 10 percent for every 5 percent decrease in the S&P 500 index.
My investigations of whether the leveraged ETFs actually deliver on their objectives shows that they don’t, not even close. For example, in the two-year period ending in early 2010, one double-inverse S&P 500 ETF (brought to my attention by a reader who owned and asked me about it) fell by 43 percent, a period during which it should have increased about 28 percent because the S&P 500 index actually fell by 14 percent.
Seeing the pros and cons of trading ETFs
One supposed advantage of trading ETFs is that, unlike the regular index mutual funds that I recommend in this book, you can trade (buy or sell) ETFs throughout the day when the stock market is open. When you buy or sell an index mutual fund, your transaction occurs at the closing price on the day that you place the trade (if the trade is placed before the market closes).
Sure, the flexibility sounds alluring, but consider a few drawbacks:
Timing your moves in and out of the stocks: Being able to trade in and out of an ETF during the trading day isn’t a necessity, nor is it even a good practice. In my experience of working with individual investors, most people find it both nerve-racking and futile to try to time their moves in and out of stocks with the inevitable fluctuations that take place during the trading day. In theory, traders want to believe that they can buy at relatively low prices and sell at relatively high prices, but that’s far easier said than done.
Paying a brokerage commission every time you buy or sell shares: With no-load index funds, you generally don’t pay fees to buy and sell. But with ETFs, because you’re actually placing a trade on a stock exchange, you pay a brokerage commission every time you trade. For example, if you buy an ETF with a seemingly low expense ratio of 0.1 percent and you pay $10 to trade the ETF through an online broker, that’s equal to paying two years’ worth of management fees if you invest $5,000 in the ETF!
Figuring out if the current price on an ETF is above or below the actual value of the securities it holds: Because ETFs fluctuate in price based on supply and demand, when placing a trade during the trading day, you face the complication of trying to determine whether the current price on an ETF is above or below the actual value. With an index fund, you know that the price at which your trade was executed equals the exact market value of the securities it holds.
Because ETFs trade like stocks, you can use limit order and stop loss orders as well as sell them short or trade them on margin. I generally don’t recommend these strategies for nonprofessional investors.
Identifying the best ETFs
For the vast majority of investors, you don’t need to complicate your lives by investing in ETFs. Only use them if you’re a more advanced investor who understands index funds and you have found a superior ETF to an index fund you’re interested in.
Be sure to check whether the ETF you’re considering is selling at a premium or discount to its net asset value. (You can find this information on the ETF provider’s Web site after the market’s close each business day.) I strongly encourage you to employ the buy-and-hold mentality that I advocate throughout this book — don’t hop in and out of ETFs. You should also only buy the ETFs that track the broader market indexes and that have the lowest expense ratios. Avoid those that track narrow industry groups or single, smaller countries. See Chapters 11 through 15 for specific ETFs that I like for specific situations.
If you’re truly interested in investing in ETFs and you’re a more advanced investor, make sure that you know which funds are the best ETFs. The best ETFs, like the best index funds, have low expense ratios. My top picks among the leading providers of ETFs include the following:
Vanguard: Historically, Vanguard has been the low-cost leader with index funds and now has the lowest cost with their ETFs as well. If you’re interested in finding out more about ETFs, be sure to examine Vanguard’s ETFs. Vanguard also offers the Admiral Share class for bigger balance customers ($100K+) of its index funds that match the low expense ratio on their ETFs. (www.vanguard.com; 800-662-7447)
Wisdom Tree: Developed by Wharton business professor Jeremy Siegel, this new family of indexes is weighted toward stocks paying higher dividends. These ETFs have higher fees but offer a broad family of index choices for investors seeking higher-dividend-paying stocks. Note: Other ETF providers do offer a number of value-oriented and higher-dividend-paying stock funds. (www.wisdomtree.com; 866-909-9473)
Two additional and large providers of ETFs include the following firms (beware that many of their ETFs are pricey or too narrowly focused):
iShares: BlackRock has competitive expense ratios on some domestic ETFs based on quality indexes, such as Russell, Morningstar, S&P, Lehman, Dow Jones, and so on. (www.ishares.com; 800-474-2737)
State Street Global Advisors: This group uses indexes from Dow Jones/Wilshire, S&P, Russell, and MSCI, among others. (www.ssgafunds.com; 866-787-2257)
Mimicking Closed-End Funds: Unit Investment Trusts
Unit investment trusts (UITs) have much in common with closed-end funds (discussed in Chapter 2). UITs take an amount of money (for example, $100 million) and buy a number of securities (such as 70 large-company United States stocks) that meet the objectives of the UIT. Unlike a closed-end fund (and mutual funds in general), however, a UIT does not make any changes to its holdings over time — it simply holds the same, fixed portfolio. This holding of a diversified portfolio can be advantageous because it reduces trading costs and possible tax bills.
With that said, UITs do suffer from the following major flaws:
Significant upfront commissions: Brokers like to push UITs for the same reason that they like to pitch load mutual funds — for the juicy commission that they ultimately deduct upfront from your investment. Commissions are usually around 5 percent, so for every $10,000 that you invest into a UIT, $500 goes out of your investment and into the broker’s pocket. Although UITs do have ongoing fees, their fees tend to be lower than those of most actively managed mutual funds — they’re typically in the neighborhood of 0.2 percent per year. As an alternative, you can buy excellent no-load funds (see Chapter 7), which, because you’re buying the fund directly from an investment company and without the involvement of a broker, charge you no commission. The best no-load funds also have reasonable management fees, and some charge even less than UITs charge (such as the index funds that I discuss in Chapter 10).
Lack of liquidity: Especially in the first few years after a particular UIT is issued, you won’t readily find an active market in which you can easily sell your UIT. In the event that you can find someone who’s interested in buying a UIT that you’re interested in selling, you may have to sell the UIT at a discount from its actual market value at the time.
Lack of ongoing management oversight: Because UITs buy and hold a fixed set of securities until the UIT is liquidated (years down the road), they’re more likely to get stuck holding some securities that end up worthless. For example, compared to the best bond mutual funds (see Chapter 12), bond UITs have had a greater tendency to end up holding bonds in companies that go bankrupt.
Customizing Your Own Funds Online
On some Web sites, various services pitch that you can invest in a chosen basket of stocks for a low fee — and without the high taxes and high fees that come with mutual fund investing. Like most political “Vote for me and not my opponent” ads, these services misrepresent both their own merits and the potential drawbacks of funds.
These “create your own funds” services pitch their investment products as a superior alternative to mutual funds. One such service calls its investment vehicles folios, charging you $29 per month ($290 if paid annually) to invest in folios, each of which can hold a few dozen stocks that are selected from the universe of stocks that this service makes available. The fee covers trading in your folios that may only occur during two time windows each day that the stock market is open. The folio service states that orders that are placed between 11 a.m. and 2 p.m. are processed starting at 2 p.m.; orders that are placed between 2 p.m. and 11 a.m. are processed starting at 11 a.m.
So, in addition to the burden of managing your own portfolio of stocks, you have virtually no control over the timing of your trades during the trading day. (You can place traditional orders at whatever time the market is open but you’ll be assessed an additional fee of $3 per trade.)
The site also says, “Mutual funds impose fees that can be very high — and hard to calculate.” I agree with that statement. However, without doing too much homework, an investor can easily avoid high-fee funds. For example, an investor can invest in the best index funds for an annual fee of 0.2 percent per year or less. Thus, an investor would need to have in excess of $150,000 invested through this folio service to come out ahead in terms of the explicit fees.
In addition, you need to be aware of additional fees. One folio service’s Web site says (in fine print, of course) that it “. . . does charge for certain special services and does receive payment for order flow.” You must be ready to shell out the dough if you
Want to wire money out of your account — $30
Need a copy of a prior statement or transaction — $10
Hold any restricted securities (which are subject to SEC Rule 144) — $75
Close out an account — $50
The site further warns, “Note: These are today’s prices and fees, which are subject to change periodically.”
You’re simply not going to get the same level of service (and comfort) when dealing with a Web-site-based service as you do when dealing with the leading fund companies that I discuss in this book. The companies that I recommend have trained representatives available by phone. Understanding and evaluating the performance of self-created funds is difficult, and unlike mutual funds, these funds have no standards or easily accessible services that report and track the performance of your customized folio (see Chapter 17 for more information on adjusting your portfolio).
It seems to me that folio services are geared toward those people who want to hold individual stocks, who trade a lot, and who seek to cap their annual trading costs. Although I prefer investing in the best mutual funds, you can invest in stocks of your own choosing — as long as you do so with a long-term perspective. But if you were going to simply buy and hold individual stocks, why would you want to pay a Web-site-based service $290 per year?