Are ETFs a Good Fit for Your Retirement Portfolio?

ETFs can be a great choice for active investors and can offer savings that blow mutual funds out of the water.

Jan 17, 2014 at 6:39PM

ETFs (exchange-traded funds) can be a great addition to your retirement portfolio at any stage in the game. Whether you are a new investor or are nearing retirement, ETFs can be the perfect solution for diversifying your portfolio and gaining market exposure while keeping expenses low.

While ETFs have many upsides, there are some things you should consider before jumping in.

How active of an investor are you?
One of the biggest advantages ETFs offer in contrast to mutual funds is that they can be traded like a stock, but they generally require more work than investing in mutual funds.

Bid-ask spread
Liquidity can make a big difference when it comes to trading ETFs. The more heavily traded an ETF is, the smaller the bid-ask spread will be. In a heavily traded ETF, the bid-ask spread naturally narrows because there are plenty of buyers and sellers.

For example, iShares MSCI Emerging Markets (NYSEMKT:EEM) is a heavily traded ETF. Averaging around 63.5 million shares in daily trading volume for the last three months, this ETF is unlikely to have a bid-ask spread of more than a few cents at any given time. A heavily traded fund like iShares MSCI Emerging Markets is optimal for investors who do not want to spend hours watching the bid-ask spread waiting for just the right moment to pull the trigger.

Premium/discount
Similarly, ETFs trade at a premium or a discount. Unlike mutual funds, which trade at a single price for the day, ETFs trade at a premium or discount in relation to their underlying net asset value. For investors who buy and hold, this is less important. If you are an investor who has entered the ETF market because you like to trade a lot, however, it is important to be aware that bid-ask spreads and premiums and discounts can affect your returns positively or negatively over the long run.

An extreme example of premium/discount swing is iShares MSCI Philippines (NYSEMKT:EPHE), which experienced a more-than 10% swing in premium and discount over nine days last June. Investors looking to make a large buy at that particular moment could have unknowingly become winners or losers without even trying. This low-volume ETF also experiences big gaps in bid-ask spread because it does not trade nearly the volume of other ETFs. This fund only trades an average of about 200,000 shares on a daily basis, and bid-ask spreads can be more than $1.50 per share. Compare that with iShares MSCI Emerging Markets, which trades 185 times that many shares in a single day on average and usually has a bid-ask spread of about a penny.

Automatic investing
Many investors like to put their savings on autopilot. If you prefer to "set it and forget it," investing in mutual funds may be a better choice. Most brokerages offer periodic investing options for mutual funds on a monthly, quarterly, or annual basis. Periodic investing is only available for mutual funds, not ETFs. Investors who like to dollar-cost average by spreading their buys throughout the year should consider sticking with mutual funds. Most brokerages waive fees for periodic investing and allow investors to make smaller buys after their initial buy into the fund. Keep in mind that if you choose to purchase ETFs on a monthly basis instead, there are usually fees that will accompany each trade.

Will ETFs help you reduce fees?
Nothing erodes the value of a retirement account faster than fees. They may seem small, but over time they add up. Over the course of 30 or 40 years of saving, the difference of 1% in fees can be the difference between retiring comfortably and having to work a lot longer.

ETFs offer tremendous value when it comes to fees. For example, Vanguard FTSE Emerging Markets ETF (NYSEMKT:VWO) offers investors exposure to mostly large-cap emerging-market stocks at a very low 0.18% expense ratio. Given the net average expense ratio of 0.58% for the category, investors who buy and hold stand to save a substantial amount of money over the long term.

ETFs are often less expensive than their mutual-fund counterparts. While the expense ratios of ETFs may be lower than a mutual fund with similar holdings, it is important to factor in other expenses, such as commission charges. Some brokerages offer commission-free trades on certain ETFs. This can be a great way to save money in fees when trading ETFs; however, it is important to carefully examine the ETF to make sure it will help you meet your goals. Cheap doesn't always mean good.

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Fool contributor Melinda Melendez has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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