3 Reasons Why I Like ETFs

So I don’t like mutual funds.  What do I like?  I mostly use ETFs (exchange traded funds) in my practice.  ETFs are taking the investment world by storm, and if current trends continue, will overtake mutual funds in this decade or the next. 

Here are three of the reasons.  

1.  You know what you’re getting

The basic passive ETF invests in a certain asset class or strategy, and does not deviate from it.  For example, State Street’s S&P 500 SPDR invests in the 500 largest U.S. stocks.  That commitment doesn’t change.  Next month, they aren’t going to change the rules and invest in largest 100 stocks or the smallest 2000 stocks. 

You might wonder what investment firm would do that.  The answer is that many mutual funds do.  The most common form is called asset creep.  A mutual fund may start out investing in small stocks, but as more money pours into their fund, they have a problem investing the money.  So, they buy larger stocks that are more liquid.  That’s a problem if you want to invest in small stocks. 

Other ETFs will invest in a certain strategy, such as the top 50 highest yielding stocks.  Again, if this is the strategy you sign up for, you don’t want it to change.  Many mutual fund companies will blur the lines overtime, and eventually the strategy evolves into something much different than when you first invested.

2.  You pay rock-bottom expenses 

You know from my last post that the average mutual fund expense ratio is 1.5%.Trading expenses add in an estimated 0.85% more, on average.Years ago, investors wanting to cut costs would use Vanguard’s or TIAA-CREF’s mutual funds.Today, investing in the Vanguard 500 costs 0.17% annually, or 17 cents for every $100 invested.However, the Vanguard Large Cap ETF costs just 0.09% annually, almost half of what the index fund costs.It invests in the same 500 stocks.

Think about this for a moment.Let’s say you want to buy a new car.One dealer in town is asking $30,000, and the other dealer is asking $16,000 for the exact same car.Which car will you buy?

3.  You don’t get saddled with someone else’s tax bill  

A mutual fund is like a swimming pool.When you invest in one, you are jumping into the same pool as every other investor in the fund.The actions of other investors in the pool affect you.On the other hand, with an ETF every investor has their own swimming pool.It’s identical to everyone else’s, but it is still their own pool.

Why does this matter?Perhaps you decided to buy into a mutual fund late last year that was up 25% year to date.However, from the day you bought it until the end of the year, it did nothing.You still will get a big tax bill if the fund sells some of its stock holdings.It really is lousy when you make no money but pay taxes on it anyway.With ETFs, those tax problems are greatly reduced.

For all of these reasons, and many more, ETFs are now the savviest way to invest for most people.