ETF Investments? Not Now. Here’s Why.

I don’t make ETF investments presently. In fact, I think ETFs stink right now – even ETFs that don’t charge commissions.

Several months ago, one of my favorite Wealth Pilgrims from Arizona asked me for a full explanation of what exchange-traded funds (ETFs) are. Don also asked me why I don’t use them right now.

I promised Don I’d answer his question, but in order to do so I have to give you some background about ETF, index fund and mutual fund evaluation. If you already understand (actively managed) mutual funds, index funds and ETFs, you can skip Part I. Tune back in on Thursday for Part II.

For everyone else, if you are or ever will be an investor, it’s super important to understand the tools at your disposal. Let’s get started.

In order to understand ETFs, you have to understand a little about actively managed mutual funds and index funds first.

What is a mutual fund?

A mutual fund is simply a basket of stocks or bonds (or stocks and bonds). The company who puts a mutual fund together raises lots of money from individual investors – $10 from me, $100,000 from you and so on and uses this money to build mutual fund holdings. Investors give mutual fund companies money to invest on their behalf.

They often do so because they want to take advantage of the expertise the fund company assembles. This is called an “actively managed mutual fund” because the fund is actively managed (a manager buys and sells stocks; a research team is put to work looking for special circumstances; etc.). Lots of activity. They hope this expertise leads to greater mutual fund performance. We’ll see if it works out.

Often the term “mutual fund” is used when the person means to say “actively managed fund.” Correct them…but forgive them. They just don’t know better. The fund company hires “experts” to manage the assets, and the investors get to take advantage of those experts’ money management skills.

What does the company get out of it?

They charge fees…lots of fees sometimes. For example, if the fund company manages $100 million and they charge 2% each year, they earn $2 million dollars each year regardless of how much the investors make. Not a bad racket. And that’s exactly why index funds were invented.

What’s an index fund and how are they different from other mutual funds?

I pointed out that actively managed mutual funds have fancy managers and other expensive personnel. Are they the best investments to make, or are there alternatives? What about index funds?

Index funds are a type of mutual fund that doesn’t have huge costs. They fire everyone they can and sell everything that isn’t nailed down to the floor. They get rid of the managers and the research departments. They drive their expenses down to the lowest level possible. Whereas the typical actively managed mutual fund has expenses of 1.5% each year, an index fund could charge .3% (or less). That means you’ll save 80% if you buy index funds instead of actively managed mutual funds. (Keep in mind that not all index funds are created the same. Read about tracking error and you’ll understand this better.)

On top of the cost reduction, index funds cause fewer tax problems and often perform better than actively managed mutual funds.

Index funds deliver both of these results because they don’t do much trading. In fact, an index fund just buys the stocks of the companies that make up an index and holds on to them. The only time stocks are bought or sold is when the people who determine what is in the index decide to change the components. If you own an index fund, the return you’ll get will be pretty close to the return of the index.

For example, if you purchase an S&P 500 index fund and hold on to it for a year, your fund will do almost as well as the index itself. The only reason it won’t ever do as well as the index is because your index fund does have some (although very tiny) expenses while the index itself doesn’t.

Why do index funds outperform most mutual funds?

Because most mutual fund managers aren’t all that great on a consistent basis. In fact, most fail to outperform the indexes. Historically, only 20% of the mutual funds do better than their index. That means that 80% do worse. Ugly… So if you add this all up, index funds are cheaper and they outperform most actively managed mutual funds.

What about ETFs?

ETFs are just like index funds – only better. ETFs are also a basket of stocks, just like index (and actively managed mutual) funds. But they are much closer to an index fund than an actively managed mutual fund. They don’t have a fancy manager or other high-cost expenses. Their management expenses are very low (just like index funds). Stocks held within ETFs are rarely changed. This helps reduce your tax consequence. And like their index fund brethren, ETFs outperform about 80% of all active funds.

So how is an ETF different from an index fund?

In one simple way. ETFs are bought and sold during the day like stocks or bonds. As such, when you place your order, you know the price you’re going to get or pay for your shares in the ETF. This is one difference in the ETF versus mutual fund decision.

Index funds and actively managed funds don’t work that way. With these types of funds, once you place your order (assuming you do so before 4 PM EST) you won’t know what the price is until several hours later. Usually, around 7 or 8 PM EST.

There are a variety of reasons why mutual funds and index funds are only priced at the end of the day, but it’s late, I’m tired and it doesn’t matter for our conversation.

Just know that the main difference between owning an ETF versus an index fund is that the ETF is priced during the day and sells like a stock. You can put limit orders on ETFs. You can sell them short. You can buy them on borrowed money. You can do all these things that you can’t do with mutual funds or index funds.

Are the differences between ETFs, mutual funds and index funds all that important?

Not to most investors. For most of us, using ETFs is more convenient than actively managed funds or index funds. The other benefits mentioned above aren’t all that useful to most of us.

Since the performance and expenses are about the same with either the ETF or index fund, the ETF is usually a better choice between the two.

OK. So now you have the background. On the face of it, ETFs look like the hands-down best alternative for investors. If I love them that much, why don’t I use them?

I’ll be happy to tell you…when you come back for Part II.

On Thursday, I’ll continue this series and tell you why mutual funds are a better choice for me (and just maybe for you) right now.