Exchange-traded funds—commonly referred to as ETFs—are all the rage. While there are several excellent reasons to use an ETF over the seemingly archaic traditional mutual fund, they are not a universally preferable solution.
First, to be fair, let’s review a few reasons why ETFs can be a better solution than mutual funds.
ETFs generally have lower associated costs than comparable mutual funds. This isn’t news, I know, but since costs are one of the few variables over which we have control as investors, I don’t mind flogging this deceased ungulate.
The expense ratio is the most obvious cost reduction. For example, the legendarily inexpensive Vanguard 500 Index Fund has an expense ratio of 0.17 percent, while Vanguard’s S&P 500 ETF has a barely noticeable expense ratio of 0.05 percent. This makes ETFs an ideal choice for investors making a sizable, broadly-based, one-and-done purchase.
But for new investors building a portfolio through small, regular contributions, reduced transaction costs may be an even better reason to consider an ETF over a mutual fund. Even low-cost brokerage platforms charge fees to buy and sell some mutual funds. These fees can be $25 or more. And by the way, if the fund is on a “no transaction fee” platform, the chances are pretty good that you’re paying a higher expense ratio to cover the fees charged by that platform to the fund family.
If your position is $100,000, a $15 ticket charge barely registers. But if you’re investing $200 per month or rebalancing a $5,000 Roth IRA,consider searching for no-fee ETFs to populate your colorful asset-allocation pie chart.
Tax efficiency is the second most popular rallying cry heralding the ETF advance, and again, for good reason. Upstart fund company Fidelity explains it well: “A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to reallocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment.”
The inherent structure of most ETFs drastically reduces their exposure to unintentional taxable events, giving them a leg up over traditional mutual funds. But only in taxable accounts.
Why, then, would an investor ever shy away from ETFs in favor of their graying older siblings? Here are three reasons why I don’t use ETFs:
1: Life is complex enough without overly complex ETFs.
While they appear simpler and more efficient than traditional funds, some ETFs are a great deal more complex and even gangly. This complexity has to do with what the ETF actually owns. If you want to buy gold or silver, for example, you’ll be able to buy ETF shares that represent holdings of the physical, underlying commodities. If, however, you want to buy an oil ETF because you believe the price of oil will go up, it’s likely that your ETF will actually hold oil futures, not the physical commodity. This is a fundamental difference often misinterpreted as a minor nuance. It has led to hordes of disappointed oil ETF owners who’ve experienced historical underperformance relative to the price of oil.
For the record, I’d prefer you not speculate on individual commodities, anyway. Instead, consider a diversified commodity holding, and only do so in tax-privileged accounts. As Larry Swedroe, principal of Buckingham Asset Management and co-founder of BAM Advisor Services, often says, “If you don’t understand an investment well enough to explain it to a fifth-grader, don’t buy it.”
2. The temptation to trade ETFs can be too great.
As they transition from novelty to ubiquity, it seems that now there’s an ETF for everything. Yes, you can more than adequately create a diversified portfolio. But ETFs also tempt investors to speculate. You can purchase ETFs that track not only markets but market volatility or sentiment or momentum or even U.S. Market Neutral Anti-Momentum, an ETF that shockingly doesn’t seem to exist anymore. You can find inverse ETFs to short (bet against) your market of choice. You can even find ETFs that will double or triple that bet, turning the investing process into more of a table game than a discipline.
And as you may have guessed, most of these weird ETFs also suffer from the complexity dilemma because they are composed almost entirely of derivatives.
3. Human beings can still make a difference, you know.
ETFs make it almost impossible for a manager to add value, where mutual fund managers have more flexibility. While Swedroe is an advocate for what a growing number of financial advisors refer to as evidence-based, rather than active, investing, he observes that good mutual fund managers can load on factors, such as beta, size, value, profitability, quality and momentum. They also capture any value added by patient trading, which ETFs don’t do, nor do standard index mutual funds, like an S&P 500 Index fund.
Here’s the key point: This isn’t in argument over traditional index funds vs. ETFs, but about making the mistake of thinking all passive approaches to investing are synonymous. Even though all passive strategies start from a similar investment theology, there are noticeable denominational divides. So while many investors are attracted to the seeming similarities of thought behind ETFs, index investing and evidence-based investing, you can’t really replicate evidenced-based investing with ETFs.
I think the other points I’ve made start to come into play when you recognize the difference between something “similar” and something “identical”—like buying an oil ETF that holds futures versus a mutual fund that holds Canadian oil trusts. This is where a lot of investors may find themselves in trouble, presuming that ETFs are wholly good or preferable.
ETFs make sense—a lot of sense in the appropriate situation. There are, however, also several very good reasons not to use them. Your individual situation, your values, your goals and objectives will dictate if and when they make sense for you.
I’m a speaker, author and director of personal finance for the BAM Alliance. If you enjoyed this post, let me know on Twitter or Google+, and click here to receive my weekly post via email.