ETF Tradability Can Hurt Your Returns

While exchange-traded funds, or ETFs, have some significant benefits, one of their features could end up hurting your returns if you're not disciplined in your investing.

The creation of the first ETFs was a major financial innovation, providing some important benefits to investors. For all practical purposes, ETFs act like open-ended, no-load mutual funds and can be created to represent virtually any index, asset class, sector or country. Thus, an ETF that represents the S&P 500 Index will look just like an S&P 500 Index fund. The providers of ETFs tout that their unique operating structure provides the following advantages.

• The unique structure and related redemption process of ETFs has allowed them to substantially reduce taxable distributions for individual investors, making them more tax efficient than similar index funds (though not necessarily more so than mutual funds specifically managed for tax efficiency).
• They typically have lower operating-expense ratios than similar index funds.
• You can trade them throughout the day, instead of only at the close.

The New York Times noted that Kevin Laughlin, of the Bogle Financial Markets Research Center, found that in the five years through October , the dollar-weighted returns investors earned from their ETFs trailed the time-weighted returns of the funds themselves by 3 percent a year. In other words, investor returns trailed investment returns by 3 percent a year. While investors in traditional mutual funds experience the same phenomenon, their returns lagged their funds' returns by "just" 1.1 percent a year.

The bottom line is that the increased trading flexibility provided by ETFs led to investor behavior resulting in an additional loss of returns of almost 2 percent a year. This certainly more than offset any cost advantage provided by ETFs' lower expenses as well as any tax efficiency they might have provided.

Before concluding, there are two other disadvantages of ETFs that should be mentioned.

Transaction Costs Because ETFs trade like stocks, you'll incur bid-offer spreads when buying and selling. It's important to note that Laughlin's data on ETF investor returns didn't include transactions costs - strategies have no costs, but implementing them does. If the transactions costs had been included, investor returns would have been even worse. Because mutual funds trade at their net asset value, you don't pay bid/offer spreads.

Brokerage Commissions When you buy a no-load mutual fund directly from the fund sponsor, you don't incur fees. Once again, since ETFs are like stocks, you'll likely incur brokerage commissions (though some brokerage firms now offer commission-free trading on some ETFs). This becomes important when investing on a frequent basis and/or in very small amounts. Examples might be dollar cost averaging programs as well as in retirement and profit-sharing plans.

There are two lessons here. The first is that not all features are advantages -- some can be temptations likely to prove hazardous to your financial health. The second is that whether you invest in ETFs or traditional mutual funds, you're best served by having a written investment policy statement and adhering to it.

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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.