A mutual fund alternative?

Marvin Appel, MD, PhD and Brian Hufford, CPA, CFP

One of the few areas in the stock market that has attracted an increasing amount of investor interest is the use of exchange-traded funds (ETFs). Are they right for you?

Stock market indexes

A discussion about ETFs should start with a review of market indexes. An index is a collection of stocks selected to give a representative view of some part of the overall stock market. For example, the Dow Jones Industrial Average is a basket of 30 stocks designed to represent the various sectors of the U.S. economy.

Investments designed to track the movements of stock market indexes are important for individual investors because, historically, index-based investments have outperformed a majority of actively managed mutual funds.

Like an index mutual fund, ETFs hold baskets of stocks designed to track the movements of a stock market index and are constrained by the composition of the index they track. There are currently far more index investments available through ETFs than through traditional, closed-end mutual funds. ETFs track a variety of indexes, including those that represent small companies, mid-sized companies, large companies, companies expected to grow faster than the market, companies selling more cheaply than the overall market, foreign companies, and even bond market segments.

Where ETFs and open-end index funds differ is that ETFs trade on stock exchanges throughout the day. They are subject to the laws of supply and demand. Occasionally, the price of an ETF share may differ from the value of the underlying basket of stocks.1

Index mutual funds trade only at the end of the day. Regardless of the balance of buyers and sellers, the price of a share of an index mutual fund is equal to the value of the underlying basket of stocks.

ETFs or index funds?

The disadvantage of ETFs is that they carry the same trading costs as individual stocks. Depending on your arrangements with a broker and on the particular ETF involved, these costs can be significant, in some cases exceeding 0.5 percent per trade. Most no-load mutual funds do not have per-trade costs (unless you execute transactions through one of the mutual fund supermarkets). If you are adding small amounts of money at regular intervals to your investments, an index mutual fund might be a better alternative.

The advantages of ETFs include their greater variety and their very low holding expenses. Mutual funds charge expense ratios to cover their operation costs. Actively managed U.S. stock funds charge an average of 1 percent per year. Broad-based ETFs charge under 0.25 percent per year, and S&P 500-based ETFs charge only 0.09 percent per year. Many traditional index mutual funds (especially at Vanguard) have low expense ratios as well, but, in general, ETFs are the least expensive long-term investment.

Most individual investors should use ETFs when implementing their asset allocation strategy. Since index fund investments generally tend to outperform actively managed funds, consider ETFs for the different investment styles in which you might want to participate. Of course, there is no guarantee that any ETF will outperform the typical actively managed fund in the same area or that exposure to any particular investment will ultimately be profitable during your holding period.

Specific examples include: SPY for large U.S. company investments; IJR (S&P 600 small company index) for small-cap investments, and QQQ (Nasdaq 100 Depository Receipt) for technology exposure.

¹ However, certain large firms can exchange shares of the ETFs for the actual underlying shares of stock by using an elaborate mechanism. This "arbitrage" mechanism keeps ETF prices mostly in line with the value of the underlying index.