In recent years, you’ve probably heard the abbreviation ETF and wondered what it means. These low-cost investment vehicles are definitely something that investors should become familiar with, especially when starting down the road to building wealth.
ETF stands for exchange-traded fund. The overwhelming majority of these investments are similar to index mutual funds. But instead of being managed by investment managers, ETFs generate returns by owning shares that match the composition (and therefore the returns after fees) of specific indexes.
ETFs aren’t as well-known as mutual funds and most corporate 401(k) plans don’t offer them. That’s a shame because they have some real advantages over mutual funds. First offered in the 1990s, ETFs have gradually grown in popularity to hold $2.1 trillion in assets.
Unlike shares of index mutual funds, ETFs can be bought on the exchanges during the trading day at their current price, just like a stock. Index mutual fund shares, however, can only be bought or sold at the close of the trading day. This flexibility of ETFs gives investors the opportunity to get in or out quickly to seize opportunities or minimize damage from falling values.
This difference can be a both a blessing and a curse. “The biggest advantage of ETFs is the biggest disadvantage,” says Mark Salzinger, editor and publisher of The Investor’s ETF Report, a monthly newsletter on the subject. “So those who invest in them can act like a trader. This seems great on the surface, but it isn’t good for most people because fear and greed can enable a short-term orientation, which can hurt them.”
What Salzinger means is that, while being able to trade ETF shares at the drop of a hat can be a good thing for those with the skill to do it right, it’s not really necessary for many individual investors who are interested in the long term.
Yet, there are other advantages of ETFs that can benefit individuals, especially if they have the discipline not to trade every time they see a big price movement in the indexes to which their ETFs are linked. These advantages include:
- Lower costs. ETFs tend to be the cheapest funds you can own. The average ETF expense ratio — the percentage taken out of accounts annually to pay the cost of operating the fund — fell to 0.23 percent at the end of 2015, according to Morningstar, the fund-rating company. While some others have expense ratios of about one half of one percent, ETF expenses range down to an ultra-low one-twentieth of 1 percent.
Over the long haul, differences in ETF fees can make a big difference in total returns. For example, let’s say you invest $10,000 in two ETFs and add $5,000 a year to these investments for 20 years. Both generate a 10 percent annual return. Over this period, one of the ETFs, with expenses of five basis points (.05 percent), returns $270,000 (over and above the money you invested). The other, with expenses of 55 basis points (.55 percent), returns $238,000. Both ETFs track exactly the same index, so their gross returns are the same. Thus, the only issue is expenses, which has a big impact on net returns over time —a difference of $32,000 in this example.
- ETFs also give you access to narrow segments of various markets. You can invest in an ETF that tracks indexes for water or gold or companies that are buying back lots of their own shares. Individual investors can best use these highly specific ETFs as a highly flexible way to own alternative investments—those that can help protect a portfolio against risk by spreading your investment eggs into baskets that don’t track the overall market for stocks or bonds. But be careful to diversify. Don’t load up your portfolio with volatile instruments such as commodities.
If you want to get a small measure of commodity exposure at low cost to balance out your overall portfolio—depending on your age, goals and risk tolerance—consider a commodity market ETF that invests across many sectors including precious metals, oil, grains, etc. It’s safer to get exposure that’s broad-based, and such ETFs are widely available with low expenses.
- Income flexibility. Most index mutual funds tend to automatically reinvest dividends from the companies whose shares they own, but with ETFs, you can arrange to get these dividend checks—a big plus for retired people looking for regular income from their portfolios. Just make sure to buy an ETF with the lowest possible expenses. You don’t want an outsized slice of your dividends going to the ETF’s management company.
- You get to own shares of dozens or even hundreds of companies, something that would be quite complicated and expensive if you were to try to build a portfolio by buying individual stocks.
- Control over taxes. Mutual funds periodically distribute gains to investors, whether or not you’ve participated in them. For example, you bought a mutual fund in November. The fund is required to distribute income to shareholders for the entire year in the form of interest, dividends and capital gains, so you get stuck with the tax bill even though you didn’t enjoy gains. Not so with ETFs. You pay taxes only on your gains if the shares are held in a taxable account.
There are also some key caveats for ETF investors:
- Don’t be lured in by the high returns projected for so-called leveraged ETFs. They tend to have high expenses and carry significant risk, as managers roll from one futures contract to the next. The goal of using these contracts is to amplify the returns of the funds. But these highly leveraged investments can sometimes go down in value even when the investments involved go up over time. In that event, you lose money even if the market goes in the direction that you’re hoping it will!
- There are many international ETFs to choose from, but investors often neglect to consider the ramifications of currency fluctuation on their returns. When you buy a foreign ETF (or mutual fund) you own two moving parts—the underlying stocks and the strength of the dollar versus other currencies. Shares of international investments decrease in value as the dollar rises, which has been happening for some time.
- Pay attention to the volume of trading. There’s more than 1,400 ETFs available and some of them are thinly traded. This means you may not be able to sell them for their full value at any given moment or the ETF might close and return your money. So it’s wise to stick with the ETFs that have a net asset value of at least $1 billion.
As with any investment, ETFs have upsides and downsides. But as an asset class, they hold benefits that other types of funds don’t tend to offer.
Any opinions expressed in this column are solely those of the author.
Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree. He does not own the investments mentioned in this column.