Exchange-traded funds (ETFs) have been one of the fastest-growing investment products in recent years, attracting millions of investors with their trading flexibility and low expenses. But as more and more of these funds are rushed to market, expenses on some ETFs have begun to creep upward. In fact, some ETFs now charge more than many actively managed mutual funds. Why are some of these funds so expensive?
Forecast: rising expenses
Using Morningstar's online screening tool, you can find dozens of ETFs that clock in with huge expense ratios of 0.95% or more. With many active funds charging 1% or less, these ETFs seem more costly than they should be.
But ETFs that charge high fees tend to serve a much different purpose than most inexpensive, broad-market exchange-traded funds. Such funds tend to allow investors to invest in obscure, narrow segments of the market; or make leveraged bets on which direction the market will move.
Given that these sorts of instruments are difficult to find elsewhere, the added expenses for these ETFs may seem reasonable. After all, one should expect to pay more for funds that allow investors to engage in these otherwise operationally difficult strategies. While paying up for an ETF that holds shares of commonly held stocks like ExxonMobil
But odds are good that any investors who are interested in selling the market short or leveraging to twice the market's return will not be long-term holders of these types of ETFs. Most people who buy these more expensive ETFs will likely be making frequent trades into and out of these funds, racking up further trading costs and commissions. These funds are made for market-timers, not long-term investors; that should make it pretty clear whether these funds are right for you.
Proper care and feeding of ETFs
Exchange-traded funds can be excellent investment vehicles for investors, but only if they are used properly. Just because these funds can be traded throughout the day doesn't mean they should be. ETFs can provide an inexpensive way to get passive exposure to the market, and that's how they are best used by investors. Unfortunately, too many folks take advantage of ETFs' trading flexibility to make frequent trades in an attempt to make a quick short-term profit. Not only are most investors really bad at successfully timing the market, but they also oftentimes pay more for those exotic funds that allow them to do so.
In a perfect world, people who buy ETFs would do so because they are satisfied with the market rate of return. And if you are seeking the market rate of return, costs should be of primary importance to you. You want the fund that can get the job done for the smallest expense. Anything above that, and your ETF will start to lag the market, weighed down by unnecessary costs.
So if you are thinking of buying exchange-traded funds, stick to broad-market, well-diversified funds with low expenses. A fund like Vanguard Total Stock Market ETF (VTI), for instance, combines big companies like Apple
Although some of the new ETFs may seem alluring, they are too expensive to warrant a place in your portfolio. There is no reason why anyone should overpay to own an exchange-traded fund. Leave the pricey funds to someone else -- your portfolio will thank you.
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This article was originally published on Sept. 26, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Apple and Marvel Entertainment are Motley Fool Stock Advisor recommendations. Johnson & Johnson is a Motley Fool Income Investor selection. Pfizer is a Motley Fool Inside Value pick. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.