September 2007
Investing: A bargain alternative to mutuals
Illustration by Bob Eckstein
Few financial products have created as big a stir in recent years as exchange traded funds, or ETFs. Much like the more familiar
index mutual funds, ETFs are portfolios of stocks or bonds that track particular market indexes.
Unlike mutual funds, however, ETFs trade like stocks. So, for example, you can buy or sell them during the day at that moment's price, rather than wait for the unpredictable end-of-day price on a mutual fund. You can also take advantage of sophisticated trading techniques, such as issuing stop-loss orders that instruct your brokerage firm to sell shares automatically when prices fall below a certain level.
ETFs have two principal selling points:
But ETFs also have their downsides. The major one is that unlike no-load mutual funds, they must be bought through a broker.
That can mean paying a commission every time you trade shares.
At the discount broker Charles Schwab, for example, buying ETF shares would cost you $12.95 for each online trade, or more if you did the transaction by phone.
If you like to invest or withdraw small amounts of money on a regular basis--say, monthly--you would probably be happier with traditional mutual funds. The brokerage commissions you'd have to pay on all those ETF transactions would take too big a bite.
However, if you have a chunk of money to sock away from time to time, you might want to join the fast-growing ranks of ETF investors. In 2006 alone, the assets held in ETFs grew by more than 40 percent, to $422 billion. Some experts predict that assets will reach $2 trillion by the end of 2010.
If you thinking of investing in ETFs, consider these tips:
Unlike mutual funds, however, ETFs trade like stocks. So, for example, you can buy or sell them during the day at that moment's price, rather than wait for the unpredictable end-of-day price on a mutual fund. You can also take advantage of sophisticated trading techniques, such as issuing stop-loss orders that instruct your brokerage firm to sell shares automatically when prices fall below a certain level.
ETFs have two principal selling points:
- They are often cheaper to operate than a comparable mutual fund and, as a result, tend to pass along lower expenses to their
investors.
For example, the average index mutual fund that tracks the S&P 500 charges its shareholders about 0.4 percent in annual expenses, while similar ETFs have expenses of 0.1 percent or less. - ETFs also tend to be more tax-efficient than traditional mutual funds. The latter are required by law to make capital-gains
distributions to their shareholders each year, based on the profits they've reaped in selling securities.
That sometimes results in a big, unexpected tax obligation for the investor, even if the fund doesn't seem to have risen commensurately in value. ETFs can also make distributions, but because they do far less buying and selling, their distributions are likely to be minimal.
Because of that difference, ETFs can be a better choice than mutual funds for investing outside of a tax-deferred retirement plan, such as an IRA. If you're investing within a tax-deferred plan, either funds or ETFs will do the job.
At the discount broker Charles Schwab, for example, buying ETF shares would cost you $12.95 for each online trade, or more if you did the transaction by phone.
If you like to invest or withdraw small amounts of money on a regular basis--say, monthly--you would probably be happier with traditional mutual funds. The brokerage commissions you'd have to pay on all those ETF transactions would take too big a bite.
However, if you have a chunk of money to sock away from time to time, you might want to join the fast-growing ranks of ETF investors. In 2006 alone, the assets held in ETFs grew by more than 40 percent, to $422 billion. Some experts predict that assets will reach $2 trillion by the end of 2010.
If you thinking of investing in ETFs, consider these tips:
- Make sure the ETF really is cheaper. In some rare instances, exceptionally frugal mutual funds will beat ETFs at their own game.
For example, when we checked data compiled by Morningstar, an investment information publisher, we found that the iShares MSCI EAFE Index ETF (EFA), which tracks international stocks from the developed world, had an expense ratio of 0.35 percent. The Fidelity Spartan International Index (FSIIX), a traditional mutual fund that follows the same index, had an expense ratio of 0.1 percent.
You can find more information on ETF expenses as well as performance at Morningstar.com and ETFConnect.com. - Look into free trading. Some brokerage firms now offer free online trading, which can make ETF shares less expensive to buy and sell.
Zecco.com, for example, will let you make up to 40 trades a month without charging a commission. Bank of America's brokerage allows up to 30 trades a month without a commission, but you have to keep $25,000 in deposit accounts with the bank to qualify. Wells Fargo offers 100 free trades a year, but you must maintain a total of $25,000 in Wells Fargo accounts, including your brokerage account, to avoid those pesky commissions.
Stocks on the cheap
| These ETFs recently had the lowest expense ratios in their categories. |
|||
| Fund category | ETF (ticker) | Annualized return (3-year) |
Expense ratio |
|---|---|---|---|
| Total market | Vanguard Total Stock Market (VTI) | 13.5% | 0.07% |
| Large-cap | iShares S&P 500 (IVV) | 12.5 | 0.09 |
| Mid-cap | Vanguard Mid-Cap (VO) | 18.9 | 0.13 |
| Small-cap | Vanguard Small-Cap (VB) | 15.8 | 0.10 |
| Total foreign | Vanguard FTSE All-World ex-US (VEU) | NA (too new) | 0.25 |
