may help you sleep at night
Investors who are looking for a haven from stock
market gyrations and corporate shenanigans sometimes shift from
single stocks to mutual funds. But mutual funds can be weighed down
with fees, short-term trading restrictions and scandals of their
own. Exchange-traded funds are an alternative that many people have
been finding attractive. They're most often touted for their low
cost, tax efficiency, transparency and liquidity.
ETFs have been around since the
early 1990s, but seem to have caught fire the past couple of years.
According to data published by Investment Company Institute, the
combined assets of the nation's ETFs in March 2003 were just over
$100 billion. One year later, that figure stood at $161 billion;
by March 2005 it had ballooned to $228 billion.
There's a similarity to mutual funds in that each
ETF contains a basket of stocks that have something in common. Currently,
ETFs are based on indexes focusing on everthing from the S&P
500, to real estate, gold and other precious metals, and even China's
top 25 companies.
have become the perfect companion for the do-it-yourself investor," says
David Fry, publisher of ETF Digest. "The fees are low; it's easy to get in
and out. There's tremendous variety and liquidity."
The price you pay for a share of an ETF fluctuates
throughout the day. You buy shares on the market just as you do
with stocks. Mutual funds, on the other hand, can only be traded
once a day at the price set at the end of the trading day.
Even though you can trade ETFs like stocks, some financial
advisers discourage that.
people don't have the discipline to maintain a diversified portfolio," says
certified financial planner Bruce Brinkman of Timothy Financial Counsel in Rockford,
"They're in and out, and that's one of the drawbacks
of the ETF philosophy. People are tempted to get in and out because
you can trade them so quickly. They're working against themselves
thinking they can time the market and get ahead of the trend. Very
few succeed at that. You can't do that with mutual funds. The regular
index mutual funds have worked well for the buy-and-hold crowd.
They get their allocation set and keep it until there's some reason
to change, but they're not making quick changes."
companies, such as David Fry's ETF Trader, specialize in using market timing to
buy and sell ETFs. But that type of trading is best done with professional guidance.
tax efficiency of ETFs stems from that fact that they're not actively managed.
Only rarely are shares of the underlying stocks that make up a fund sold. That
means there are few, if any, capital gains distributions that trigger taxes for
shareholders. You'll pay taxes when you sell shares, if they've appreciated. That's
a far different situation from mutual funds where you may have to pay capital
gains taxes even if you haven't sold any shares.
"In 2001 and 2002, thousands of mutual funds
had losses but distributed capital gains to their shareholders,"
says William Suplee, CFP and president of Structured Asset Management
in Paoli, Pa.
"There were really egregious ones with 40-percent
to 60-percent losses, and the investors had to pay capital gains
tax. If you invested $50,000 in a fund and lost $20,000 and got
a $5,000 tax bill, your head would just explode."
Be aware that
just as with stocks, you'll pay a commission every time you buy or sell an ETF.
If you want to buy an index fund and periodically add more shares to your holdings,
it would probably be cheaper to stick with a no-load index fund. Also, ETFs don't
have automatic dividend reinvestment. If you want to reinvest the dividends you'll
have to buy additional shares on the market -- and pay a commission.
also have an expense ratio just as mutual funds but, generally, it's very cheap
compared to stock funds and index funds.
annual expense ratio|