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Are exchange traded funds the future of investing?
Larry Carrel is a big fan of exchange traded funds.
The Amherst native and former Smart- Money.com columnist calls ETFs “mutual funds for the 21st century” and touts them as a cost-effective way for investors to broadly diversify their portfolios.
Mutual funds do that too, but Carrel thinks ETFs are better because their fees are lower and they can be traded during the day, like a regular stock, rather than only after the stock market closes for the day, as with a mutual fund.
“It gives the investor a lot more control and a lot more power,” says Carrel, the author of a new book called “ETFs for the Long Run.”
Carrel admits that buying stocks isn’t on the top of most investors minds these days, especially with the Standard & Poor’s 500 index down 40.5 percent this year. But in spite of the short-term pain, he says investors need to think about the long term.
“If you believe America will come back and the American economy will come back, you need to be invested in the stock market,” he says.
To Carrel, the best way to do that is through ETFs, which trade like a stock but are actually broad-based portfolios that mimic major stock market indexes or invest in specific industries or certain countries or regions.
“They’re index funds, mainly,” says Carrel, who estimates that 95 percent of the 700 ETFs now trading are designed to mimic a certain index.
Because most ETFs aren’t actively managed, they also tend to have lower expenses than mutual funds, allowing investors to put more of their money into their portfolios, instead of the pockets of their fund company.
“The one thing you can control is fees,” says Carrel, a 1981 Williamsville North High School graduate. “Ninety-nine percent of the time, the ETF is going to give you the lower cost for the same strategy.”
Because ETFs can be bought and sold during the day, investors have even more control over the timing of their sales and purchases — which could be a valuable advantage for investors in these volatile days, when it’s not unusual for the stock market to rise and fall by 5 percent in a single day.
Exchange traded funds also tend to be more tax-efficient than mutual funds, which must distribute their accumulated capital gains to investors each year.
In a down market like this, that can leave mutual fund investors with an unhappy surprise: Their funds are way down for the year, but they also face a significant tax bill on capital gains because the fund had to sell shares to meet the demand for redemptions during the sell-off.
Most exchange traded funds don’t distribute capital gains annually. Just two of the 178 iShares ETFs are expected to make year-end distributions this year. Instead, most ETF investors pay capital gains based on the gain or loss of the fund’s stock price at the time they sell. That gives ETF investors more control over when they want to take their capital gains.
“You’re getting a cheaper product. You’re getting a more tax-efficient product. And you’re getting a product that has more transparency,” because it typically is based on an index, rather than a fund portfolio that is only disclosed twice a year, Carrel says.
Yet ETFs have some disadvantages, too. Because they trade like a stock, investors must pay a brokerage commission to buy them. While that can be as little as $10 or so for investors using a discount brokerage, the commissions can make it too costly for investors who like to make smaller purchases at regular intervals.
That strategy, known as dollar cost averaging, is popular with small investors because it is budget- friendly and it also imposes a discipline through its regular purchases that allows them to buy fewer shares when prices are high and more shares when prices are
low.
Fund tracker Morningstar Inc. estimates that an investor making a $5,000 initial investment and $200 each month for the next 10 years, would pay $374 in fees to buy a low-cost Vanguard S&P 500 index fund that earned a 10 percent annual return.
But making the same investment in an ETF that tracks the S&P 500, at $13 in commissions per trade, would run up $1,801 in costs over the same 10-year period.
“To pay a commission on $100 or $200 every month, an ETF may not be your best investment,” says Carrel, who will be giving a lecture on ETFs at the University at Buffalo School of Management at 5:30 p. m. Monday in Room 122 of Jacobs Hall.
ETFs have steadily gained popularity over the last decade. This year 114 ETFs were launched, with an average market capitalization of just $25 million. By comparison, the biggest and oldest ETF, known by its ticker SPY, which tracks the Standard & Poor’s 500 index, has $79 billion in assets.
In October, ETF trading volume totaled a record $3.3 trillion, or 38 percent of all U. S. stock trading volume, according to National Stock Exchange research.
But at a time when virtually no investments can escape losses, all the big ETF competitors have seen the value of their ETF assets fall sharply along with the markets.
Assets in ETFs were down to about $440 billion in late October from $620 billion at the end of last year, according to a report from Morgan Stanley. But at a time when investors are pulling cash out of stock mutual funds, ETFs saw a net inflow of $100 billion in investor cash through the first 10 months of the year.
ETF advocates expect money will continue flowing into the ETF market as a whole. But some believe most of that money will go to well-established ETFs reflecting broad market indexes, rather than higher-risk, narrowly targeted ETFs mimicking the performance of a single industry, overseas market or commodity. For example, investors these days can choose among ETFs that focus on alternative energy stocks, or gold, or South African stocks.
Of the 716 ETFs that Morgan Stanley now counts in the U. S. marketplace, just over one-fifth mirror specific sectors or industries.
As for who sponsors ETFs, Morgan Stanley found that Barclays Global Investors holds a 47 percent market share based on ETF assets, with State Street Global Advisors second at nearly 27 percent. Vanguard, which has recently seen strong flows of money into its ETFs, ranks third at 8 percent.
“Vanguard has been gaining market share rapidly by racing to the bottom in expenses,” said Dan Dolan, who runs State Street Global Advisors’ Select Sector SPDRs, a group of nine ETFs that that divide the Standard & Poor’s 500 into broad sector index funds.
The Associated Press contributed to this report. e-mail: drobinson@buffnews.com
