Eventually they will wear you down!
The fans of ETFs (exchange traded funds) are on full assault to get you to make the switch from mutual funds, go to your plan administrator and have them added to your 401(k), and convince you that low cost is the best reason of all to invest in the trade-able funds.
This doesn’t have me making the switch in the near-term from mutual funds to ETFs. My 401(k) also doesn’t seem to have any near term intentions of doing so either. But that doesn’t mean you won’t think you are missing something important.
Are exchange traded funds as good as they sound?
First things first!
Exchange Traded Funds are a really good idea. Some of their attributes are incredibly attractive and the one you hear the most of course is the low cost. If you put them side-by-side with a similar mutual fund, you will definitely see a huge savings with the ETF model.
But you must compare apples to apples and even more importantly, Macintosh to Macintosh. Even so much a single variation in the holdings or a balancing of those securities in the fund eliminates any accurate comparison other than the price.
What they hope to explain to you and what these advocates of this security often put at the top of their collective lists along side of fees is the ability to trade these securities throughout the day.
Major brokerage houses have often waived the cost of trading – the brokerage fee assesses on the buy order and the sell order – to entice you even more.
This is not a bad thing on the surface. Investors can make mistakes. But the best use of ETFs is found in the buy-and-hold which negates the free trading or frequent trading of these securities.
Risks of trading ETF’s over stocks
What ETF fans often suggest as well is what is known as risk mitigation. This leaves you with the feeling that the risk in these investments is somewhat diminished. Risk as we all know is real with every investment and does not go away with the ETF.
The question is: is it lessened? The short answer is yes it does. This is due to the ETF structure.
ETFs are baskets of securities that are purchased and held in advance of you ever putting a single dollar in.
Unlike mutual funds which must take your dollar and buy additional share of the underlying securities to issue you your shares, ETFs sell you what they own.
This eliminates redemption risks, the cost of selling stocks in a mutual fund to satisfy exiting shareholders. If there is ever a “run” on the fund, the shareholders who do not sell are left with the cost of selling the shares to pay the shareholders who are leaving.
This has tax consequences that are difficult to quantify. (The mutual fund manage may have to sell winners in the portfolio which creates a tax-able event.)
So if you buy an ETF that is exactly like its mutual fund counterpart, you will save a great deal. But suppose an ETF mimics its counterpart but only to a degree?
This puts the onus of education on your shoulders, which some ETF fans fail to accurately portray.
If you are buying an ETF because you want to purchase a similar mutual fund but are barred because of steep entry fees, you might want to reconsider.
Are ETF’s a cheaper alternative for investing?
With so many investors looking for yield in fixed income, an investment that has risk that seems like low risk, the latest entrants into the ETF marketplace seem logical, even smart.
Consider the behemoth of the fixed income world: PIMCO.
Once managed by William Gross, the PIMCO funds are the benchmark of fixed income excellence. And unless you have a million dollars, this fixed income zenith is often beyond the scope of the average investor.
But you can but the ETF for around $100 a share.
According to Oly Ludwig and Dave Nadig, writing for IndexUniverse:
“It’s crucial to note that the Pimco Total Return ETF won’t technically be the same portfolio as the Total Return mutual fund.”
They continue with
“[the] One big difference is that it won’t, for now, make use of derivatives the way the mutual fund does. That said, Pimco has made clear in filings that it intends to use derivatives in TRXT at some future date.”
Simply put, the two funds are not the same and possibly never will be. This will impact the advertised return and not give you what the mutual fund counterpart will.
That might mean greater like risk (of not being able to produce the returns you had hoped for) and possibly add to the disappointment for those that thought this fund would be what the mutual fund counterpart is.
So what do you do? You must educate yourself, look beyond the advertised pluses to the unadvertised minuses and more importantly, stay diversified. ETFs do not mitigate your involvement – it just seems that way.