Is Wall Street Getting Lazy?

Is your money manager getting lazy? Count the number of ETFs in your portfolio for a litmus test.

ETF (exchange-traded fund) overload is growing in the ranks of professional money managers. According to Greenwich Associates, a financial services consulting firm, two-thirds of hedge funds, half of all financial advisors, and one-third of pension plans use ETFs. As one CFP told the Journal of Financial Planning, his firm has moved 30% of the assets it manages from mutual funds into ETFs and separately managed accounts. As of last month there was $172.12 billion invested in ETFs, according to the Investment Company Institute, although that's still just a fraction of the $7.4 trillion commanded by mutual funds.

There's nothing inherently wrong with ETFs -- and in fact, there's a lot that's downright perfect about this investment vehicle. But there's no reason to shell out top dollar to your full-service broker or financial planner to buy something that you can get for a fraction of the price on your own. Or, as my colleague Mathew Emmert quips: "Why pay 1% to guys who are just a bunch of mutual fund schleppers?"

In theory a professional stock picker -- whether a mutual fund manager or your own private Warren Buffett on speed dial -- should have nose to grindstone finding superior businesses to round out their clients' portfolios. While an ETF trades like a stock, it is simply a bite-sized version of an index mutual fund. So when you're advised to buy the Utilities SPDR (AMEX: XLU  ) for your portfolio, you'd be smart to question why your pro couldn't come up with a superior utility stock or two that could handily beat the index of its peers.

Don't let lazy pro stock pickers tarnish the beauty of ETF investing. The pros are definitely onto something.

ETFs are very tax efficient. By construction, investors don't pay any capital gains from internal turnover. Of course, when you sell your ETF shares, should you be fortunate enough to do so at a profit, you'll be on the hook for capital gains taxes. In the eyes of our friendly Internal Revenue Service, it would be just like selling any other stock for a profit.

There's an ETF to represent virtually any segment of the market. ETFs are an ideal way to add an indexing element to your portfolio -- everything from the bond indexes to the Wilshire 5000. According to ICI, there are more than 140 flavors of ETFs out there. Want to track the Nasdaq 100 with an ETF? No problem -- try QQQ. Looking to follow Hong Kong stocks? You can do that, too with EWH -- MSCI Hong Kong Index Fund. Or if you want to invest in the more pedestrian but Fool favorite S&P 500, that's easily within reach by buying SPY. REITs? Commodities? Yup, there are ETFs for those, too.

They're easy for individual investors to buy. Got a brokerage account? Then you're set to start investing in ETFs. (If not, it's easy to do.) ETFs trade on the American Stock Exchange and have snappy nicknames like Cubes, Spiders, and Diamonds. They also have tickers, just like any other publicly traded company, and can be bought or sold any time the market is open (a big difference from index mutual funds). ETFs can also be optioned, shorted, and margined (tread with caution here, though). Traditional index funds, on the other hand, can be redeemed only at the closing price of each day.

They're cheap! Much like most of their index fund brothers, ETFs have a very cost-efficient structure. Annual expenses range between 0.1% and 0.65% and are deducted from dividends. Remember, it's important to keep your costs under control. Shoot for one with a ratio below 0.4%. The only other fees you'll encounter with ETFs will be your broker's trading commissions.

Whatever you do, don't overpay through a pro to invest in an ETF. Doing so could cancel out the very thing that makes ETFs an ideal addition to a portfolio.

Dayana Yochim champions index investing but currently owns no ETFs.


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