Lately, a lot of pundits have been bashing ETFs (exchange-traded funds), but we want to take a step back: What are ETFs, and should you be concerned?
We caught up with our investing expert Manisha Thakor for her insights and opinions. In short, an ETF is an investment that lets you invest in a stock market index like the S&P 500. (For a more thorough explanation, click here.)
Index Funds vs. ETFs: The Gap vs. H&M
The most traditional way to invest in an index is through an index mutual fund, which also tracks a specific financial market. Index funds and ETFs can fulfill nearly identical functions in your portfolio; their main differences come through their fee structures and the frequency at which they can trade. ETFs let you trade as often as you want, whereas index funds only let you trade once per day.
A way to look at index funds and ETFs is like comparing a black shirt from the Gap and one from H&M (assume that the prices are on par—so, say it’s Gap sale prices). A black top from either store will be roughly the same—either shirt would fill the same niche in your wardrobe, so it doesn’t make a big difference which one you choose. In the end, you might go with the one that’s on sale for a little less, or from the store that’s closer to your home.
Deciding Which Shirt to Buy
Similarly, index funds and ETFs can fill the same niche in your portfolio, so you can base your decision on what’s cheaper or more convenient for you. ETFs sometimes charge lower maintenance fees than mutual funds. Most brokerages have a selection of “no-transaction-fee” mutual funds (whereas ETFs have small sales commissions but no transaction fees). Because they behave similarly, making the decision between choosing to buy an ETF or a mutual fund is usually about the fees—like choosing the shirt that’s on sale or that’s in the closer store.
So, What’s All This Hype?
“It’s become popular to pick on ETFs because the luster of this as the latest ‘new-new’ thing has started to wear off.”
However, recently ETFs have raised the ire of critics. First, exotic, non-traditional ETFs have sprung up with complicated structures, offering ways to make big, risky profits on short-term trends. In addition, because ETFs allow investors to buy and sell multiple times per day (mutual funds don’t), many were in fact doing so, a risky move that may see greater profit, but also greater losses.
In other words, to use the same analogy, instead of wearing the basic black Gap top every once in a while the way it’s intended to be worn, more investors are metaphorically getting excited about a trendier, embellished H&M top–and wearing it every single day, to every kind of event inappropriately, until it starts falling apart.
LearnVest’s recommendation is that ETFs are a perfectly fine investment vehicle, but (1) stay away from “exotic” or non-traditional ETFs that promise short-term gains, and (2) do not buy and sell ETFs frequently.
The LearnVest philosophy has always been to invest for the long run. Thakor points out that as long as you do that, the ability to trade at the drop of a hat or use new, complicated ETFs is moot. She says: “Right now I think it’s just become popular to pick on ETF companies because the luster of this being the latest ‘new-new’ thing in the market has started to wear off.”
Basically, Stay the Course and You’ll Keep Out of Trouble.
Pay the most attention to what you can control: how much you save, the asset allocation you choose, the fees you pay, and your ability to keep focusing on the long term. Never buy anything, whether it’s a mutual fund or an ETF, that you don’t understand. Once you’ve got those factors down, you can choose the best mix of mutual funds and ETFs to create the right portfolio for your specific needs … at the right price.
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