Advantages of Exchange-Traded Funds - dummies

By Russell Wild

Exchange-traded funds (ETFs) were first embraced by institutions, and they continue to be used big-time by banks and insurance companies and such. Institutions sometimes buy and hold ETFs, but they are also constantly buying and selling ETFs and options on ETFs for various purposes.

For noninstitutional types, the creation and expansion of ETFs has allowed for similar juggling (usually a mistake for individuals); but more importantly, ETFs allow for the construction of portfolios possessing institutional-like sleekness and economy.

ETFs let you say goodbye to high mutual fund fees

The average mutual fund investor with a $150,000 portfolio filled with actively managed funds will likely spend $2,000 (1.33 percent) or so in annual expenses. By switching to an ETF portfolio, that investor may incur trading costs (because trading ETFs generally costs the same as trading stocks) of perhaps $100 or so to set up the portfolio, and maybe $50 or so a year thereafter.

But now his ongoing annual expenses will be about $375 (0.25 percent). That’s a difference, ladies and gentlemen of the jury, of big bucks. We’re looking at an overall yearly savings of $1,575, which is compounded every year the money is invested.

Loads, those odious fees that some mutual funds charge when you buy or sell their shares, simply don’t exist in the world of ETFs.

Capital gains taxes, the blow that comes on April 15th to many mutual fund holders with taxable accounts, hardly exist.

ETFs provide building blocks for a better portfolio

In terms of diversification, many portfolios include large stocks; small stocks; micro cap stocks; English, French, Swiss, Japanese, and Korean stocks; intermediate-term bonds; short-term bonds; and real estate investment trusts (REITs) — all held in low-cost ETFs.

Yes, you could use other investment vehicles, such as mutual funds, to create a well-diversified portfolio. But ETFs make it much easier because they tend to track very specific indexes. They are, by and large, much more “pure” investments than mutual funds.

An ETF that bills itself as an investment in, say, small growth stocks is going to give you an investment in small growth stocks, plain and simple. A mutual fund that bills itself as an investment vehicle for small growth stocks may include everything from cash to bonds to shares of General Electric.

ETFs are better regulated than mutual funds

While scandals of various sorts — hidden fees, “soft-money” arrangements, after-hours sweetheart deals, and executive kickbacks — have plagued the world of mutual funds and hedge funds, very few ETF scandals have touched the lives of most people. That’s because the vast majority of ETFs’ managers, forced to follow existing indexes, have very little leeway in their investment choices.

Unlike many investment vehicles, ETFs are closely regulated by the U.S. Securities and Exchange Commission. And ETFs trade during the day, in plain view of millions of traders — not after hours, as mutual funds do, which can allow for sweetheart deals when no one is looking.