How to Use ETFs
Exchange-traded funds are the fastest-growing but most misunderstood investment vehicle of the last few years. ETFs have been around only since 1993, and didn’t start to take off until the late 1990s. Let’s see how these mutual fund substitutes might fit into your investment strategy.
An ETF is similar to a mutual fund. The investor buys shares in the ETF, and the ETF owns a number of stocks. But there are significant differences between ETFs and mutual funds.
An ETF trades like a stock, which means an investor can buy or sell any time the market is open. With an open-end mutual fund, an investor generally has to submit a buy or sell order by 2:00 p.m., and the trade is made at the closing net asset value for the day. This can be an important difference for investors who use ETFs with a trading strategy or to any investor on days when the market is making a big move. Even for a long-term investor the difference might compound over time.
Since they trade like stocks, ETFs can be purchased on margin and can be sold short. While I rarely recommend such strategies, they can be useful. For example, an investor might have significant long-term positions in equity mutual funds. He is convinced that the market is due for a substantial decline, but he does not want to sell because of the capital gains taxes that would be due. This investor can sell short an ETF that tracks a broad-based market index. Gains from the short sale would offset losses in the mutual funds if the market declines.
ETFs also have very low expense ratios. The SPDR 500, which tracks the S&P 500 index, has an expense ratio of 0.11%. That is significantly lower than the expense ratio on most mutual funds, even index funds. Fidelity and Vanguard lowered expense ratios on index funds to 0.10%, primarily to prevent assets from migrating to ETFs.
ETFs are able to maintain low costs because they often do not have to buy and sell stocks even as investors are buying and selling the ETF. Instead, the ETFs exchange stocks and ETF units. You don’t need to know the mechanics. But know that trading costs are not incurred by ETFs much of the time.
ETFs also tend to be tax efficient, even more tax efficient than many index funds. Since the exchanges of stocks for ETF units are tax-free, the manager can trade out those stocks with the lowest basis and therefore the highest potential gains. An ETF generally has to make taxable transactions only when the components of the index it tracks are changed. Unlike even index mutual funds, most ETFs have made few taxable distributions over the years.
ETFs also offer more variety than index mutual funds. You invest in almost any market index and any segment of an index. You can buy growth or value stocks, large or small cap stocks, or the whole market. There are ETFs covering each of the major market sectors, such as energy, technology, financial, and basic materials. You can buy a foreign stock index or the indexes of select foreign countries. There are ETFs specializing in bonds, gold, and real estate investment trusts.
Despite their innovations, ETFs are not for every investor and do have disadvantages.
Almost all ETFs are index funds. They only track a selected index. An investor will not get the benefit of active management, except his own decisions to buy and sell market sectors or different markets. If you do not want to track an index, you will have to seek another investment.
Since they trade like stocks, ETFs also incur the same commissions as stocks. You can keep commissions low by trading ETFs through one of the online discount brokers. Or you can use a low-cost fractional share broker, such as mystockfund.com. Otherwise, ETFs are not economical for investors who will make fairly small, frequent investments. The commissions would more than offset the lower costs and taxes the ETF has compared to a no-load, low expense mutual fund. For example, suppose you will invest $10,000 in equal monthly installments over a year. If you invest in an ETF, the ETF would deduct $7 for the year in expenses, plus at $8 per trade you would pay $96 in commissions. If you buy a no-load index fund, you would pay only $19 in expenses for the year, deducted directly from the fund. Even if the index fund makes a taxable distribution, it still would have a higher after-tax return.
ETFs also do not necessarily trade at net asset value the way mutual funds do. There can be bid-ask spreads, especially for ETFs with low trading volume. That means you will pay a discount or premium to the value of the portfolio, depending on what the market for the ETF is doing that day. For a buy-and-hold investor the spread will have a very small long-term effect. For traders or those making frequent transactions, the difference can mount.
An ETF also can have tracking error, which means its returns differ from those of the index. The ETF cannot reinvest dividends as quickly as the published index can. Of course, there are fees and expenses to deduct and costs incurred with rebalancing and index changes. For some indexes, the ETF cannot exactly replicate the index. It has to buy a sample of securities that its managers believe will get the same or similar performance. Some will get higher returns than the index, but some will have lower returns.
Not all ETFs are as tax-friendly as others. Single-country ETFs lose some tax benefits if more than 25% of the fund is in the securities of a single issuer. Breeching that barrier is not unusual for a single-country index. To avoid a breech, the ETF must sell some shares and distribute taxable gains. Also, some dividends will not qualify for the 15% tax rate, because the ETF did not own the shares for the minimum holding period.
Keep in mind that a sector or single-country ETF might be dominated by just a few stocks. For example, the Dow Jones U.S. Energy Index (IYE) is 40% invested in ExxonMobil and Chevron. You won’t get much diversification and might be better off simply buying the key individual stocks and avoiding the ETF’s expenses.
Despite the large number of ETFs, you might not be able to build a full portfolio solely with ETFs. You will not find ETFs that invest in high yield bonds, municipal bonds, international bonds, or commodities (other than gold and real estate). If you want to invest in value stocks, you have only the limited criteria the index makers use to separate value and growth stocks.
To invest in ETFs, an investor might need to become something of an expert in indexes. Suppose an investor decides to invest in small cap stocks. The investor must choose between ETFs tracking the Russell 2000, S&P 600, and Dow Jones US Small Cap indexes, plus growth and value variations of those indexes.
There are several ways ETFs can enhance your investing.
One way to use ETFs is with a trading strategy. Some of my readers do this with my Invest with the Winners ETF trading model. This is a trend-following system that invests in the best-performing ETFs using specific buy and sell signals. The variety of ETFs makes it possible to almost always be invested in the top performing sector or country in the markets. Trading ETFs can be better than trading mutual funds. Purchases and sales can be made at any time during the day, instead of having to wait for the day’s closing price. Most brokers charge lower transaction costs for ETF trades than for fund trades. In addition, many funds will charge redemption fees on short-term owners.
Another good use of ETFs is for long-term holdings. If there is only one purchase and sale, an ETF is cheaper than a comparable index fund. For the long-term holder, ETFs also offer the ability to build a more customized portfolio than is possible with traditional index funds. Sectors and countries can be overweighted or underweighted as the investor desires.
ETFs also can be used for special situations and to fill holes in a portfolio. If an investor decides energy stocks will be strong for the next year two, he simply can buy an energy ETF for a few dollars of commissions. He doesn’t have to research different energy mutual funds or stocks. As explained earlier, selling short an ETF can hedge a portfolio position the investor does not want to sell.
There are several sources of details about ETFs. Ameritrade has an ETF Center on its web site that is open to anyone as is www.investor.com/etf. The issuers of ETFs offer details about their funds at www.ishares.com, www.rydexfunds.com, www.spdrindex.com, www.street-tracks.com, and www.vanguard.com.
