Why You Should Invest in ETFs

They're cheap, transparent, and can easily plug holes in your portfolio, author says.

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Exchange-traded funds, which share the design of mutual funds but trade on exchanges like stocks, are no fad in the financial world. So far in the United States, ETFs have attracted more than $600 billion in assets. That's tiny compared with the $12 trillion invested in conventional mutual funds, but ETFs are gaining fans quickly.

Tom Lydon, president of the Newport Beach, Calif., firm Global Trends Investments, is one of a growing number of financial advisers who favor ETFs over mutual funds. Lydon, coauthor of a new book, iMoney: Profitable ETF Strategies for Every Investor, and a blogger at ETF Trends, says between 80 percent and 90 percent of his firm's clients now have pure ETF portfolios. Lydon recently spoke to U.S. News about why investors are gravitating to ETFs, where the industry is headed, and which funds to buy now. Excerpts:

Why choose an ETF over a mutual fund?

We're seeing more and more investors make that choice, and the big reason is that many individual investors have lost faith and trust in the mutual-fund industry. After a big run-up in the 1990s and a big decline in 2000-02, many investors felt that the fund companies were going to take care of them. But when the S&P 500 declined 47 percent and the Nasdaq declined 75 percent, these mutual funds felt the pain as well. During this time, investors were calling their fund companies, wanting to hear what their fund manager was doing, and some would say that they're thinking about making a move. Meanwhile, people at the funds were telling them not to time the market, to take a long-term perspective, and they were very much motivated to try to keep people in the funds. Many people lost money.

After that was the mutual-fund scandal. And, finally, the straw that broke the camel's back: After the market declined, analytical firms on Wall Street comparing performance found that between 80 percent and 90 percent of active managers don't beat their benchmarks. With mutual funds not even beating the market, investors are saying, 'If I can't beat the market, I'll buy the market' in the form of ETFs.

Investors like ETFs because they can understand specifically what they're buying. As time goes on and technology and reporting capabilities improve, you'll see more and more advisers and investors shifting money to ETFs. They're not a fad, and they're not going away. We're probably only in the second or third inning. The $600 billion in ETFs assets represents only 5 percent of the overall mutual-fund marketplace.

If you're thinking about making the switch to ETFs, what are the big considerations?

First, if a mutual-fund investor looks at their own portfolio, they need to see how their funds have performed versus their benchmarks and what fees they are paying. If mutual funds are underperforming—be it the majority or a handful—they warrant consideration to be sold and replaced with ETFs. From an allocation standpoint, the vast majority of mutual-fund investors have predominately high allocations to large-cap stocks, and today the S&P 500 is just about where it was 10 years ago, which is unbelievable. Meanwhile, small-caps and mid-caps have drastically outperformed. And the prognosis going forward is that they will probably continue to do so. So if you're overallocated in large caps, or if your mutual funds are underperforming their benchmarks, it's very easy to turn to ETFs. A few sources allow you to plug in your fund holdings and produce a picture of your allocation, including Morningstar and Yahoo Finance.

Although there are about 700 ETFs on the market, a lot have just come out this year. We look for ETFs to have at least $100 million in assets before we invest. Some asset classes, such as small-cap growth, are very well represented, so you have a lot of choices. Since many now have a decent track record, you can compare an ETF to the rest of its asset class. Also, a variety of providers offer ETFs based on conventional market-capitalization-weighted indexes, like the S&P 500. Others, like WisdomTree, offer fundamental indexes based more on earnings or dividends.