Though the acronym "ETF" technically stands for "exchange-traded fund," a better description might be "easy to trade frequently."
Built like funds, but as tradable as stocks, ETFs have become the domain of the buy-to-flip bunch. Take SPDRs (AMEX: SPY ) ; like the Vanguard 500 (VFINX) index fund, it mirrors the S&P 500. But rampant buying and selling has led SPDRs to -- wait for it -- 3,600% annual turnover. In practical terms, that means the average SPDRs investor holds shares for about one day.
Cheap is as cheap does
No wonder Vanguard founder and fund guru Jack Bogle has come out strongly against ETFs. In his newly published book, The Little Book of Common Sense Investing, Bogle argues, "I can't help likening the ETF to the renowned Purdey shotgun, supposedly the world's best. It's great for big-game hunting. But it's also excellent for suicide."
Exactly. Those who like to trade are more likely to buy tradable funds. But even if you're not a trader, championship mutual funds -- especially when held in a tax-advantaged account -- are often cheaper to own.
Do the math with me. The investor who builds a $10,000 position in the Vanguard 500 in thirds over the course of a year is likely to pay just 0.18% of assets -- or $18 -- for the privilege.
A similar position obtained in SPDRs would cost at least the price of three trades -- let's say $30, for argument's sake -- plus an 0.08% expense ratio, or $8. That's $38 vs. $18. Assuming that each position remains stable, it could take two or more years for the ETF's edge in annual fees to wipe out the deficit created by initial trading costs.
Don't be a sector sucker
That won't always be true, of course. If you're bent on buying a sector fund, you're likely to do better with an ETF. Consider the PowerShares WilderHill Clean Energy Index (AMEX: PBW ) . Its 0.70% annual expense ratio is well below the wealth-destroying 1.98% a year you'd have to pay for the Guinness Atkinson Alternative Energy (GAAEX) fund. And you'd still get exposure to both Fuel Systems Solutions (Nasdaq: FSYS ) and Echelon (Nasdaq: ELON ) , among others.
Still, this isn't much of an argument. Sector-specific investments of any sort -- whether fund or ETF -- are less likely to outperform the broader market, given how easily they can fall out of favor. Think of what's happened to the WilderHill Index since oil prices began to normalize, for example.
Profiting from the champions' choices
What really makes funds the better choice in this debate? Expertise. ETFs are quantitative instruments that rise and fall according to the benchmarks they serve. The top managed mutual funds, on the other hand, can deliver years of market-crushing performance on the cheap.
Think of the investing legends who've made their names managing superior funds: Peter Lynch, Marty Whitman, Bill Miller, and Wally Weitz, just to name a few. Investing with any of these top performers over the course of decades would have made you rich.
Today's top managers are no different. Motley Fool Champion Funds advisor Shannon Zimmerman has constructed a portfolio of aggressive growth funds that charge just 0.66% on average. These peerless picks have spanked the S&P 500 by more than five percentage points since inception. (Click here for a free peek at which funds made Shannon's list.)
The Foolish bottom line
Look, I'm not here to bash ETFs. Held for years, they can make wonderful investment vehicles. But as Bogle points out, that's rarely what occurs. More often, they become like stocks, but with the added blight of an annual bar tab that's as bad for the liver as it is for your returns.
Championship funds, on the other hand, can be cheap to acquire and own. And if managed well, they can deliver decades of market-beating returns while allowing you to sleep soundly at night. That's as good a deal as any investing offers -- and no ETF can match it.
Fool contributor Tim Beyers writes weekly about personal finance and investing. Have a Foolish money tip? Tell him. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. All of Tim's portfolio holdings can be found at his Fool profile. His thoughts on Foolishness and investing may be found in his blog. The Motley Fool's disclosure policy puts the "oo" in "moola."