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As resident Fool Fund advisor Amanda Kish noted yesterday, low fees are one of the primary selling points behind exchange-traded funds like the Vanguard Total Stock Market ETF (NYSE: VTI ) and SPDR S&P 500 Index (NYSE: SPY ) . So what are the other advantages of investing in ETFs? Which ETFs will benefit if deflation becomes more of a threat? And which ETFs will benefit if gold prices continue to rise? I recently asked ETF Database Analyst Michael Johnston.
Mac Greer: Just to start out on a more general note, what is the case for investing in ETFs versus investing in indexed mutual funds or investing directly in stocks?
Michael Johnston: ETFs have kind of burst onto the scene in the last couple of years, and a lot of the market share that they have captured has come at the expense of mutual funds. Now, compared to the actively managed mutual funds, the differentiating factor is generally a cost one, and ETFs can get down to as low as six basis points in fees a year, whereas the active ETFs are usually in the one to one-and-a-half range.
But you asked specifically about the indexed mutual funds, which tend to be quite a bit cheaper and almost as cheap as ETFs. I think the biggest differentiating factor there for investors is the ability to trade these ETFs essentially like stocks throughout the day. And particularly in the current environment, that is something that people I think really value a lot and really appreciate more than ever. And by "current environment," I am simply referencing the fact that triple-digit swings in the Dow are now the rule rather than the exception. Volatility can be pretty significant so the ability to move in and out of positions through the course of the day is something that a lot of people value.
When we talk about [ETFs] compared to investing directly in stocks, I think that the big factor there is just that immediate diversification that most of these ETFs offer in terms of being able to buy a single security and get access to sometimes up to 5,000 companies through that single security. There are still going to be people out there who do get into the nitty-gritty of the financial statements and the nuances of a company, but ETFs have allowed investors to implement more of a top-down approach instead of digging through the balance sheet and trying to find a buy in an individual company. ... I have heard people say, and I agree with it, that the wrong play in the right sector is still a wrong play. So you would be right about energy companies going through the roof, but if you happen to pick the wrong one, you are going to end up with a bad outcome. Whereas if you go with an ETF, there is enough diversification that you can pay off on that more high-level play if you are right.
Greer: What ETFs stand to benefit if deflation becomes a real threat?
Johnston: Deflation is a tricky thing. Deflation always comes from complex factors, but there are a few asset classes and a few ETFs that generally do well. One position you like to be in is being in a fixed income or a bond ETF. It is a fixed-income stream that isn't going to depreciate, even if prices decline. There are a couple out there that I like in particular.
The Vanguard Long-Term Corporate Bond Index ETF (Nasdaq: VCLT ) is a long-term corporate bond that pays a pretty good coupon rate. Obviously, if deflation kicks in, those dollars that are paid out are only going to grow in value, and having that fixed-income stream locked in is pretty attractive.
In the same light, but in the Treasury area instead of the corporate bond area, is the iShares Barclays 20 Year Treasury Bond Fund (NYSE: TLT ) , which is a long-term Treasury bond ETF. It's not going to have quite the yield of corporate bonds, but it is still going to be fairly attractive. And the fact that it is locked in for the long term is really something that is pretty interesting.
Greer: And gold prices are still very high, of course. What ETFs benefit most from the rise in gold prices?
Johnston: Sure, there are a couple of them out there. The SPDR Gold Trust (NYSE: GLD ) and the iShares Comex Gold Trust (NYSE: IAU ) . Both are very similar in that they invest in bars of gold bullion that are stored in secure vaults. So those are two incredibly popular funds and probably the two best ways to play a rise on gold prices.
Greer: And what are the biggest mistakes investors make when investing in ETFs?
Johnston: I think the biggest mistake is investors just not doing their homework and not really understanding the nuances and the complexities of a given ETF, or more generally, just simply what is in the underlying ETF. There are more asset classes available than ever before, and generally that is a good thing, but the other side of that coin is that investors now have the ability to invest in leveraged ETFs, and they have the ability to invest in ETFs that use exchange-traded futures written on commodities to obtain commodity exposure.
We hear horror stories of investors who didn't take the time to do the homework. So I like to tell people, and I have heard this advice before, too, if you can't understand what the ETF does in five minutes, and you can't understand what factors are going to drive the ETF, and what the underlying holdings are, and how the ETF functions, you need to walk away and stick to something that you are able to comprehend.