ETF Investing: How to Invest in Exchange-Traded Funds

An exchange-traded fund is a basket of stocks (or, more rarely, bonds, commodities, or currencies) that trade as a single unit, like a mutual fund. ETFs generally track an index such as the S&P 500, or a smaller sliver of it, such as telecommunications stocks or shares in small companies. Unlike with a mutual fund, which is priced once a day at the market’s close, the price of an ETF changes throughout the day along with the market’s ups and downs (something that proved costly for some investors during the May “flash crash”).

ETFs often have lower management fees than already low-cost index mutual funds — Vanguard Total Stock Market ETF (VTI), for example, charges just 0.07 percent a year (or $7 on a $10,000 investment), vs. 0.18 percent for the comparable traditional fund, Vanguard Total Stock Market Index (VTSMX).

And their structure makes them supremely tax-efficient, sometimes even more so than index mutual funds. For example: In a market downturn, the manager of a traditional fund might be forced to sell positions to meet redemptions, potentially triggering a capital gain for shareholders. Because of their structure, ETFs do not have to sell shares when investors head for the exits.

All these features give ETFs two sets of fans: Buy-and-hold index investors, who appreciate the funds’ low costs and tax efficiency, and active traders, who like the ability to buy and sell large groups of stocks quickly and easily all day. That appeal to both ends of the investing spectrum helps explain the enthusiasm for these funds. ETF assets top $800 billion, according to the Investment Company Institute. What’s more, 40 percent of all the trading on the New York Stock Exchange is in ETFs, according to Morningstar ETF analyst Scott Burns. That popularity is showing no signs of slowing.

Before the Fidelity, Schwab, and Vanguard shift, every time you bought shares of an ETF, your brokerage would typically charge a $2 to $9 trading fee — a cost you can usually avoid with a mutual fund. If you were investing, say, $100 every two weeks, that $9 transaction fee would make an ETF much more expensive than a comparable index mutual fund — wiping out any cost advantage the ETF had. So the free trades are a clear win for investors who dollar-cost average, or for anyone who has just a small sum to put into a fund.

Rick Ferri, author and chief executive of Portfolio Solutions, a financial planning firm that invests about 70 percent of clients’ assets in ETFs, hopes the free trades and the attendant focus on ETFs draw more investors to index investing. ETFs can give you exposure to both broad swaths of the market, as well as narrower segments of the market that you think will outperform. “If I think financials are undervalued, why wouldn’t I buy them all?” says Morningstar’s Burns. “Why take on the idiosyncratic risk of one particular company?”

For all their merits, though, ETFs are nothing more than a way to reach an investment goal — so don’t let their benefits lead you astray. For instance, intraday pricing might tempt you to buy and sell more frequently, all the more so now that trades are free. “We’re not fans of intraday trading and wouldn’t want to see retail investors doing more of that,” says Lane Jones, chief investment officer for Evensky & Katz, a financial planning firm in Coral Gables, Fla., that uses ETFs frequently. Even the biggest benefit of ETFs, the virtual lack of an annual tax bill, isn’t necessarily reason to invest, Jones says. “We like ETFs for their tax efficiency, but if they’re held in an IRA, we’re indifferent.”

In addition, while ETFs can be a good way to make a bet on a particular market sector, advisors warn against buying funds that track thinly traded parts of the market. Pricing is inefficient, and the value of the underlying securities can vary widely from the price of the ETF.

That doesn’t happen in highly traded areas of the market, because — through a process called arbitrage — big institutions capitalize on any premiums or discounts and, in doing so, eliminate any difference between the price of the underlying securities and the price of the ETF. But if the stocks or bonds don’t trade much, it’s tougher for the big investors to play the arbitrage game. “I use mutual funds for asset classes that are less liquid,” such as municipal bonds and stocks of very small companies, Ferri says. Because it’s just a giant pool of money, a mutual fund’s net asset value is always the value of the assets it holds, divided by the number of shares in the fund.

Given the popularity of ETFs, many firms are eager to roll out new varieties, not all of which are suitable for individual investors. Case in point: leveraged ETFs, which have proven to be so easily misunderstood that federal regulators have stepped in. These funds use borrowed money to double or triple an index’s return. Trouble is, that also exaggerates any losses, especially when the funds are held for more than a day. Financial advisors are near unanimous on steering investors away from the likes of the Direxion Daily Energy Bull 3X (ERX), which tries to deliver three times the return of the Russell 1000 Energy Index.

Andy O'Rourke, vice president in charge of marketing at Direxion, agrees that leveraged ETFs should be used by traders, not buy-and-hold, long-term investors. He says the problem, however, lies not in the funds themselves, but how they are used. "You wouldn't use a toaster to cook a turkey," he says.

The latest iteration: so-called actively managed ETFs. These funds don’t hew to a static index; instead, a portfolio manager makes buying and selling decisions, changing the ETF’s holdings far more frequently than with traditional ETFs. The iShares Diversified Alternatives Trust (ALT), for example, employs three primary strategies: yield and futures curve arbitrage, technical momentum/reversal, and fundamental relative value.

Baffled? You’re not alone — and that’s a good sign to invest elsewhere. “I tell people to avoid actively managed ETFs,” says David Fry, a financial planner and author of the ETF Digest. “It defeats the purpose.”

The free trades offered by Schwab, Fidelity, and Vanguard are generally on good core funds, Burns says, not the more exotic offerings. Yet free trades aren’t exactly a free-for-all. Each of the three firms has restrictions.

Both Vanguard and Schwab’s free trades are for their own ETFs only — 46 from Vanguard and just eight from Schwab. Fidelity, which doesn’t have its own ETFs, struck an agreement with Barclay’s iShares to give investors free trades on 25 of its 350 iShares funds.

Still, at each firm, you’ll be able to create a well-diversified portfolio of U.S. stocks and bonds, as well as international offerings from the commission-free offerings. Both Vanguard and Fidelity also offer sector-specific ETFs and other narrower slices of the market for no commissions.

“I don’t see a downside to this rush to offer free trades,” Ferri says, “but it shouldn’t affect your decision between ETFs and mutual funds. You might save $10, but if it’s not the right product, you’re not saving anything.”

More on MoneyWatch:

• ETFs vs. Mutual Funds: The Game Has Changed
• ETFs Hammered in Market ‘Flash Crash’


• Mutual Fund Picks: 8 Best Index Funds


• Biggest Mistake Investors Make


• When to Use ETFs — and When Not To
• What’s Behind Fidelity Waiving Commissions?