As the market has retreated this year, so have mutual fund investors. U.S. stock funds are flirting with the biggest annual selloff in their history, as investors have unloaded assets to the tune of $156 billion so far this year, according to TrimTabs Investment Research. Yet another breed of funds—most filled to the brim with stocks—has curiously managed to escape the deluge of redemptions. In fact, exchange-traded funds, which came on the investing scene in the early '90s and have exploded in popularity during the past few years, are actually drawing in investors despite the economic slump.
Compared with the country's $9.6 trillion mutual fund industry, ETFs are practically a flyspeck. But they're gaining a following among financial advisers, regular investors, and even old-school mutual fund shops like Vanguard and Pimco. Between 2005 and 2007, the assets of these unconventional funds doubled from $305 billion to $619 billion; meanwhile, the number of offerings nearly tripled to some 650 (that compares with more than 8,000 mutual funds). Today, ETF assets are down to $480 billion (blame the market meltdown for that), but cash has kept flowing into ETFs: over $100 billion so far in 2008, including $61 billion in September and October. So, why are investors bailing out of mutual funds but pouring money into ETFs? The reason, industry watchers say, is in the design.
The secret sauce. Think of ETFs as index funds with a twist. They contain diversified baskets of stocks and bonds and, with the exception of a few newfangled products, they're each tied to an index. But the big difference between ETFs and traditional mutual funds—and some say the biggest advantage—is that ETFs trade on exchanges just like stocks. That allows them to be cheaper, more tax efficient, and less cumbersome than mutual funds, as they can be bought or sold at any point during the trading day (mutual funds execute orders at the end of the day). Transparency is a hallmark of ETFs, as they're required to disclose their holdings every day.
Buying an ETF is as simple as buying a share of Apple. But instead of picking up a single stock in one trade, you can buy the technology sector or even the entire U.S. stock market. In this topsy-turvy market, investors are using ETFs as a stock substitute, says Dan Dolan, director of wealth management strategies for Select Sector SPDRs, a family of ETFs: "Volatility in the market is so great that reducing individual stock exposure has become an attractive thing to do."
Low cost. Because of their stock-like structure, ETFs don't have to spend on shareholder recordkeeping. Thanks to that feature and a low-cost indexing strategy, they're able to whittle annual expenses down to pennies on the dollar, in most cases.
Consider two funds in the same family that track the same index: the Vanguard Total Stock Market fund and the Vanguard Total Stock Market ETF. Both track an index of more than 3,000 U.S. stocks, but Vanguard's mutual fund charges 0.15 percent annually, while its ETF charges just 0.07 percent. The first U.S. ETF, the SPDR S&P 500—which trades under the symbol SPY and is pronounced "spider"—charges 0.09 percent; meanwhile, the Schwab S&P 500 index fund levies a 0.35 percent annual fee.
New frontiers. As with mutual funds, ETFs don't stop at broad-market indexes. Investors can tap into a range of investing styles, company sizes, and industries, from international and emerging markets to small-cap stocks, commodities, and real estate. Some dissect the market into specific countries, currencies, and even obscure niches such as water and global shipping (Page 68). The newest and most controversial incarnation of ETFs relies on managers, not indexes, to choose holdings (these have yet to take off).
Financial planners are increasingly using ETFs to diversify clients' portfolios and cut their costs. Oliver Tutt, managing director of Randall Financial Group in Providence, R.I., says roughly half of his firm's assets are invested in ETFs, including many of the largest accounts. "We think about what's the best way to play an asset class," he says. "Some clients want to use active mutual funds in areas where they feel an active manager can add more value, but others want to minimize fees by using ETFs as a proxy."
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.