Why Exchange-Traded Funds Make Sense

Exchange-traded funds (ETFs) have long given traditional, actively managed mutual funds a run for their money.

Since the majority of mutual funds do not keep pace with the stock indexes, legions of investors are discovering that attaining average investment returns isn't so bad. While everyone has lost money on investments during the past year, some lost even more than they would have had they better diversified their money. While hindsight is always 20/20, investors would have fared better—and perhaps much better—with ETFs.

I think this is a particularly good time to invest in ETFs. More than ever, the direction of stock and bond prices is very uncertain. The stock market may recover soon, or it might take years. Interest rates may decline with deflation or rise with inflation. We are in an unprecedented economic crisis that makes the chore of separating investment winners and losers quite challenging, if not impossible. ETFs don't try to outguess the market, and that could be an advantage right now.

In case you're not familiar with ETFs, here's a primer:

The Basics of ETFs

ETFs are like mutual funds in that they hold a bunch of individual stocks and/or bonds. ETFs differ because they are bought and sold on the stock exchange, rather than by a mutual fund company. Most ETFs are passively managed, meaning that the funds simply hold a group of investments designed to replicate a stock or bond index. On the other hand, most mutual funds involve active management—buying and selling securities in hopes of providing better-than-average returns. ETFs, however, are designed to achieve the returns of a particular stock or bond index.

(By the way, an "index fund" is very similar to an ETF in operation. The primary difference is that you buy an index fund from a mutual fund company and an ETF on the stock exchange, just as you would a stock.)

To buy and hold an ETF, all you need is an account (brokerage, IRA, retirement), in which you can hold stocks.

Proponents of indexing argue that it is futile for mutual funds to try to beat the market. Studies show that over multi-year periods, few mutual fund managers consistently beat the market indexes. So, the argument goes, why pay a manager when simply buying a fund that equals the market average will work just as well, if not better? But there are some actively managed funds that pretty consistently outperform ETFs and invest in similar securities—although several previously outstanding mutual funds faltered badly during the recently turbulent stock market.

Advantages of ETFs

ETFs offer a number of advantages—in particular, low expenses. Because they are usually passively managed, there is no need to pay expensive analysts or managers for doing research. The computer buys and sells the fund holdings instead, and it does a pretty good job to boot. The annual expenses charged to investors in ETFs are usually, but not always, much lower than those of actively managed funds. If, as many expect, we are entering a period of low investment returns, the low expenses associated with ETFs can be particularly advantageous. Investors may also find the up-front cost of buying an ETF to be lower than buying a mutual fund with an "initial load" (commission).

Most ETFs are broadly diversified across industries. For investors with a limited amount of money to invest, ETFs can be an excellent way to achieve diversification. Another possible advantage is the ability to sell an ETF soon after buying it without paying a penalty, as opposed to mutual funds, which often assess early withdrawal penalties. While you shouldn't make an investment with the expectation of selling it soon thereafter, in these scary times, selling may be necessary.

Finally, ETFs funds can be tax-friendly, in that they tend to distribute very low capital gains compared with actively managed funds. Therefore, ETFs are particularly efficacious for your taxable brokerage accounts. They also work well in retirement accounts.

Limitations of ETFs

Despite all the compelling advantages of investing in an ETF that replicates a stock or bond index, it is not the magic solution to all of your investment needs.

For example, you must be happy to achieve average market returns, even in declining markets, because that is the best an ETF can do. ETF managers are usually prohibited from using any defensive measures, such as moving out of stocks if they expect stock prices to decline. So ETFs will not protect your investment in the event of a market downturn.
When compared with some actively managed stock funds, which periodically take defensive measures when the market turns down, ETFs tend to be more volatile.

Choosing an ETF: A Snap

Considering there are nearly 20,000 actively managed mutual funds, sorting them out can be a challenge. The choice is much easier with ETFs: It comes down to picking those that give you instant diversification by tracking the broadest indexes. The biggest, broadest, most useful benchmarks are the following:

• The Wilshire 5000 Index comprises almost all U.S. stocks traded on major exchanges. Funds based on this index are often called "total stock market" ETFs.
• The Russell 2000 Index selects the smallest 2,000 of the 3,000 largest U.S. companies commonly traded, making it a benchmark for small-company (also known as "small-capitalization" or "small-cap") stocks.
• The MSCI EAFE Index is a mouthful that stands for "Morgan Stanley Capital International Europe, Australasia, and Far East Index." This mega-index comprises 21 country indexes representing most of the developed markets overseas.
• The Barclays Aggregate Bond Index includes U.S. government, corporate, and mortgage-backed bonds. Most "total bond market" ETFs are based on this. Investors may also choose among bond ETFs based upon the average maturity of the bonds they hold— for example, short-term, intermediate-term, and long-term.