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For this month's Wealth IQ Report, we discuss the advantages and disadvantages of exchange traded funds (ETFs).
Please feel free to contact me at (888) 944-7736 if you have any questions about this article and how it may pertain to your situation.
Sincerely,
Darren Whissen
The Case For and Against Exchange Traded Funds (ETFs)
There's no doubt that exchange traded funds, or ETFs, are gaining popularity. According to statistics provided by the National Stock Exchange, total U.S. listed Exchange-Traded Fund (ETF) assets reached $590.2 billion at the end of June 2008, an increase of 18 percent over $499.2 billion at June 2007 month-end. Moreover, by the end of June 2008, the number of listed ETF products totaled 804, up 45 percent from the 553 products listed at the end of June 2007.
But, what are the advantages and disadvantages of ETFs? Should investors jump on the ETF bandwagon? And, if so, what is the most appropriate way to do so?
In a recent white paper titled "Blind Faith", Lord Abbett, one of America's oldest mutual fund companies, makes a compelling argument against ETFs:
- Indexes are not passive market tracking instruments; they are designed, constructed, and maintained by people making subjective judgments. Moreover, because most Indexes are cap-weighted, they often add stocks to the index only after the stock has had a significant price run up.
- Indexes often become self-fulfilling. As investors flood an index with new cash, they are driving up the securities within the index. For example, over $1.2 trillion is currently invested in various S&P 500 index funds. How much of a price-premium do investors pay because of the constant inflow of cash into this one index? What would happen to underlying stock prices if investors began pulling their money out of this index?
- ETFs were created by exchanges to encourage frequent trading, which increases revenues for the exchanges that built them.
- If ETFs become too popular, they could eventually foster market mediocrity.
On the other hand, ETFs have certain advantages over traditional mutual fund investing. First Trust Portfolios L.P., a major provider of ETF products, outlines several key advantages in its Guide to ETFs:
- ETFs combine the intra-day trading opportunities of a stock with the diversification of a mutual fund.
- Because ETFs are index-based, they typically carry lower annual expenses than actively-managed mutual funds.
- ETFs are more tax-efficient than mutual funds.
Both white papers are worth reading:
Blind Faith - a case against ETFs
Guide to ETFs - a case for ETFs
Conclusion
So, which argument is more compelling? While those who know me know I'm no fan of index-based mutual funds, I find ETFs have their place inside a professionally-managed account. By hiring a professional money manager to determine when to buy or sell an ETF, I believe investors are able to achieve the same portfolio oversight prevalent in an actively-managed mutual fund, while keeping costs down and maintaining some tax advantages.
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Disclosures
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of an investment in debt securities will change as interest rates fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Investments in high-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income.
The opinions in the preceding commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole.
This material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict performance of any investment. Investing involves risk, including possible loss of principal. Investors should consult with a financial advisor prior to making an investment decision.
Diversification does not guarantee a profit or protect against loss in a declining market.
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