Like mutual funds, ETFs are baskets of securities. Buy one share, and get a piece of everything that’s in the basket. Typically they mimic stock indexes, though some are based on bond indexes. The most popular and well-known ETFs are Spiders (SPY), which track the Standard & Poor’s 500 Index, and Cubes (QQQ), which track the top 100 NASDAQ stocks. Some ETFs track narrow sectors of the market.
Unlike mutual funds, they trade like stocks all day long, so you can buy when the price is right. That means investors don’t have to worry about in-siders’ skimming, late trades or lousy post-close prices. They are less likely to distribute untimely taxable gains than mutual funds are. And they’re cheaper than cheap. Average ETF fees are just 0.46 percent of assets a year, compared with 1.55 for the average managed stock fund and 0.99 for the average stock index fund, reports Morningstar. Some are as low as 0.09 percent. Want that in dollar terms? Move $100,000 out of actively managed funds into ETFs, leave it there for 15 years at 9 percent earnings and you can save some $80,000 in fees.
You still have to be careful. People who bought tech-heavy QQQ for $120 a share in March 2000 are still hurting. ETFs also have a few quirks. Here’s what you should know:
You need a broker. Because ETFs trade like stocks, you have to buy and sell them through a broker, and that means transaction fees. Spending $29 every time you buy an ETF isn’t bad; if you’re buying a bunch of it and holding it for a while, you’ll make it up on the low fees. And there’s ultracheap trading on some Web sites like sharebuilder.com and foliofn.com (trades at these sites can cost as little as $4 if you are a member). But that makes ETFs unsuitable for the –dollar-cost averaging that characterizes most retirement investing. If you’re contributing to a stock fund every two weeks or month, you’re better off with a standard no-load mutual fund.
Indexing isn’t always the answer. Putting chunks of money into a broad index ETF, like the iShares S&P 500, is a great way to track the market’s biggest companies at low cost (0.09 percent annually). There’s a mountain of research and a couple of Nobel Prizes behind the idea that you’re unlikely to beat that over the long term with a stock-picking fund. But not every piece of the market is so index-friendly. Smart managers can do a better job of picking small, undervalued companies and those in emerging markets, says Wade.
You can overdo it. It’s easy to fill your cart with dozens of ETFs, specializing in everything from Internet business-to-business stocks to Brazilian companies. And some “indexes” are just too concentrated. The iShares U.S. Telecom ETF, for example, has 40 percent of its portfolio in Verizon and SBC. That’s not diversification; it’s just another stock bet. “You can be gaining pure exposure to really concentrated areas that make for an aggressive and risky portfolio,” says Bill Moeckel, another money manager who’s moving his clients into ETFs. Moeckel and other experts urge ETF investors to remember the basics of investing: simplify, diversify, cut costs and stick with it.
