The benefits of ETFs over mutual funds are pretty well-known. ETFs offer tax advantages, flexible trading options, and often lower fees than their mutual-fund counterparts.
What's not to love?
ETFs are often an excellent choice for long-term savings and retirement portfolios. However, buying ETFs requires more knowledge and care than buying mutual funds, and inexperienced investors can easily get burned. Pair that burden with investors' compulsion to make more and more trades, and the advantages of owning ETFs can quickly shift from investors to brokerages.
The ETF knowledge burden
One of the most attractive characteristics of ETFs is that they allow investors to trade funds like stocks. Instead of having to wait until the end of the day to get a price on a fund, investors can trade ETFs anytime.
But there is more to trading ETFs than there is to trading mutual funds. While knowledgeable investors can leverage bid/ask spreads and premiums or discounts to their advantage, novice investors can lose big-time, denting their overall return.
Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory, says beginning investors sometimes "see a certain ETF has performed well and they just think that's a good investment without really understanding what they're buying."
He suggests that when choosing an ETF, investors should generally look for:
- Low expenses
- High liquidity
- Large amount of assets
- Good track record compared to the fund's underlying index
- A reputable and established firm
For example, SPDR S&P 500 (NYSEMKT:SPY) is a monster ETF that tracks the S&P 500 index. It dwarfs most ETFs in size, with more than $158 billion in total assets. This fund rarely trades with a bid/ask spread more than $0.02 because of the massive volume of shares that trade on a daily basis, and the premium is often nonexistent. In fact, in the last four years, the highest premium this fund has reported was 0.08%, in June 2010.
The Vanguard Total Stock Market ETF (NYSEMKT:VTI) is another exceptionally low-expense fund that meets all of the above criteria. This ETF recently switched from tracking an MSCI index to a CRSP index. Vanguard, however, is a trusted name in indexing, and the CRSP indexes have been around for decades.
Depending on your goals, investors looking for a broader market exposure that includes international stocks should consider the Vanguard Total World Stock Index ETF (NYSEMKT:VT). Investors should note, however, that the bid/ask spread widens as the assets and trade volume of a fund decrease. For example, investors trading the Vanguard Total World Stock Index ETF can regularly expect to see a bid/ask spread of $0.10.
Choosing a highly liquid, well-funded index fund will help investors avoid some of the pitfalls of ETF investing that can erode long-term returns.
The ability to trade ETFs like stocks is like an open bar: It may be fun to go all out, but it probably won't be good for you. That's why the second key to maintaining the ETF advantage is to buy and hold.
Frequent ETF trading in a long-term account like a retirement account will slowly erode your returns. Mutual funds by nature are conducive to a buy-and-hold strategy. Buying and holding is critical to maximizing returns in an index fund.
The godfather of indexing, John Bogle, has repeatedly criticized ETFs because even though they offer lower expenses than mutual funds, when buyers are given the ability to easily trade, they'll do it -- and often. Bogle suggests that too-frequent trading creates a culture of speculators, rather than investors.
Studies have shown that in the long term, actively managed, frequently traded portfolios rarely outperform a simple portfolio of index funds managed with a buy-and-hold philosophy. For example, a recent study by Portfolio Solutions and Betterment concluded, "An investor increases their probability of meeting their investment goals with a diversified all index fund portfolio held for the long term." Additionally, the researchers found that over a period of 15 years or more, all-index-fund portfolios beat actively managed fund portfolios 90% of the time.
Maintaining your edge when it comes to long-term investing in ETFs is simple. Buy index funds that track established and trusted indexes, offer low expenses, and are highly liquid. Then hold them -- forever.