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Are ETFs bad for investors?

By Sheyna Steiner · Bankrate.com
Friday, February 17, 2012
Posted: 12 pm ET

Exchange traded funds, or ETFs, have snowballed in recent years, exploding in popularity and number. The first ETF was started in 1993. By the end of the first quarter 2011, the ETF market had grown to $1.07 trillion, according to a 2011 report from BNY Mellon and Strategic Insight, "ETFs 2.0: The next wave of growth and opportunity in the U.S. ETF market."

Here's the appeal: ETFs tend to be very low cost, and they're typically indexed rather than actively managed, so that cuts down on costs. Also, they don't trade like mutual funds; true to their name, they are traded on exchanges and are able to be bought and sold throughout the trading day, unlike mutual funds, which are priced after the close of business after the net asset value has been calculated.

ETFs are also more tax efficient than mutual funds -- even the index variety. That's because of the way ETFs are structured. Mutual fund managers may need to sell securities when investors sell shares of the fund. That can be taxable, and shareholders get to foot the bill. ETFs don't have that problem because they don't need to sell securities when investors sell.

Does that mean ETFs are the best vehicle for average investors? Maybe not, according to John Bogle, Investmentnews.com reported Thursday in the story, "Bogle: ETFs great for trading, not so great for investors."

The story quotes Bogle speaking at the Bloomberg Portfolio Manager Mash-Up in New York:

"There's no question that ETFs are the greatest trading innovation of the 21st century. But the question is, 'Are they the greatest investment innovation?' and the answer is 'no.'"

The legendary founder of the Vanguard Group and passive investing guru criticized the ability to trade ETFs throughout the day, saying it leads to poor investor decisions. He also took issue with the enormous proliferation of options which make it difficult for investors to choose the best ETF, the story reports.

At the end of the first quarter last year there were 2,605 products from 142 providers on 48 exchanges worldwide according to a study from investment company, Blackrock, titled "ETF landscape Q1 2011."

Last year's report from BNY Mellon and Strategic Insight provides some data to back up the view that investors are actively trading ETFs rather than investing on a buy-and-hold basis.

Fewer investors are content to "set and forget" their long-term allocations, and more are incorporating a tactical, or dynamic, aspect to their investing -- often relying on more-frequent adjustments to their holdings as well as using ETFs (either though short positions or other means) and other products for hedging.

The report notes that, thanks to the diversity of ETFs, they can be extremely useful for investors interested in taking a less traditional approach to portfolio construction.

What do you think? Do you use ETFs? If so, how?

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