The range of asset classes available through ETFs has allowed Average Joe investors access to corners of the market previously available only to professional traders and big-time investors, says Jim Wiandt, editor and publisher of the Journal of Indexes and publisher of IndexUniverse.com. But just because investors can doesn't mean they should include narrow and exotic ETFs. "There are places for them, such as a very specific hedge or a slight tilt," says Wiandt, who uses commodities and gold ETFs as a side dish to his portfolio. "Maybe you like the water story or the China story, but if you're doing that with the bulk of your portfolio, you're probably doing a lot of damage." Wiandt's rule of thumb? "If you don't understand it, you shouldn't be in it."
Tax advantages. Because of their unique structure, ETFs rarely throw off capital gains distributions. That's partly because most of them passively track an index that rarely changes components and also because shares are created and redeemed differently than those of mutual funds. An added bonus is that ETF investors can delay paying taxes until they sell. Deferring taxes is helpful because it allows you to keep your money invested and growing. As with mutual funds, losses up to $3,000 can be written off on an investor's tax return, and losses beyond that can be carried forward to future years.
Drawbacks. Although ETF investors win when it comes to taxes and annual expenses, trading can be costly. Brokerage commissions—which investors pay when they buy or sell shares—have been trending down in recent years, but they can still be crushing to small investors. A $10 or $15 transaction fee may not seem like a lot, but it adds up if you are consistently buying shares in various ETFs. Rudy Aguilera, founder of Helios, an Orlando investment advisory firm, suggests investing with a discount brokerage that allows free trades if you maintain a minimum balance or consolidating accounts.
The big question would-be ETF investors should ask themselves, says Wiandt, is how frequently they're planning to buy shares. "A good general rule is if you're putting in $5,000 or more, you're often going to be better off with the ETF structure," he says. That's because transaction fees add up, especially when you're investing at regular intervals.
These new funds on the block have both diehard fans and tough critics. John Bogle, who founded the Vanguard Group and is considered the father of index investing, once said ETFs "bastardized" the idea of indexing because they encourage trading over buy-and-hold investing. But the argument that investors need to be saved from themselves is becoming less relevant, says Noel Archard, head of U.S. product research development at iShares, one of the largest ETF providers. "The industry is catching up from an education point of view," he says. It's also catching up in terms of assets: Morgan Stanley expects ETF assets to grow at a 20 to 30 percent annual clip, as investors pour in cash. That should give mutual funds a run for their money.
Corrected on 12/8/08: An earlier version of this article incorrectly stated the annual expenses of the Vanguard Total Stock Market ETF and the SPDR S&P 500 ETF. Their expense ratios are 0.07 percent and 0.09 percent, respectively.