ETFs may be the investment vehicle du jour, but should you buy into one for your golden years?
ETFs, or exchange-traded funds, are hybrid investments that track indexes, commodities and baskets of assets like index funds but trade like stocks. They are growing rapidly: As of April, there were 888 ETFs in the U.S., with $829.5 billion invested in them.
That was up from 742 ETFs a year earlier, with $530.8 billion in investment assets, according to financial-services company State Street.
As ETFs catch on with the investment community, a handful of company-sponsored 401k plans are beginning to offer them as options in saving for retirement. One advantage is that they are getting cheaper, at least for now. Vanguard announced recently that it would allow its brokerage clients to buy and sell the fund company's entire lineup of 46 low-cost ETFs commission-free.
Of course, that doesn't mean you should jump into an ETF.
The hazards
For one thing, an ETF that follows a particular index of stocks may contain tracking error -- that is, it may not always provide the same returns as the index it tracks, says Philip Spoljarick, an accredited wealth management adviser at Charles Schwab in Southfield, Mich. "We want, as an investor in ETFs, the return to be close to the return that the index would have generated," he says.Tracking error can be caused by a variety of factors, including a fund's investment strategy.
For instance, some funds use a so-called replication strategy, meaning that their managers buy the same stocks at the same weights as the underlying index. Though fees may be higher with this strategy, tracking error tends to be minimal.
Other funds attempt to "optimize" their investment structures. For instance, managers may purchase only a subset of an index's stocks hoping to provide similar performance to the full portfolio, at a lower cost to trade.
Newer ETFs, or those that have low trading volumes, can contain greater tracking error simply because they may track newer or lesser-known benchmarks that are harder to replicate, Spoljarick says. To protect against this, he looks for equities-tracking ETFs that have a minimum three-month average daily trading volume of 1 million and fixed-income ETFs that average 500,000. He also prefers ETFs with a minimum of $20 million in assets.
In addition, ETFs aren't free. Even if a company drops the transaction costs, which typically range between $12 and $45, ETFs still have embedded expense ratios to keep an eye on, advisers say.
Here are some questions to consider before turning to an ETF to build your nest egg:
Is it a cheap way to track the market?
Conventional wisdom holds that investors should have exposure to the broader markets. Many mutual funds have long served this function, but ETFs may be able to do it less expensively.One reason: Because ETFs can passively track an index such as the S&P 500 ($INX) or the Dow Jones Industrial Average ($INDU), they tend to have low annual operating expenses, generally running 0.08% to 0.20%. Though actively managed or specialty ETFs can be pricier, ETFs overall don't charge a sales load -- that is, a fee levied on the purchase or sale of shares.
Mutual funds, on the other hand, can cost upward of 2% of assets but potentially offer higher returns. Take the Fairholme Fund (FAIRX), which is managed by Bruce Berkowitz, whom Morningstar recently named the past decade's top domestic-stock-fund manager.
The Fairholme Fund earned a 13.2% 10-year annualized return, beating the S&P 500 Index by 14 percentage points over the same period. Berkowitz's fee may be 1%, but investors are paying 10 times more for his expertise than they would if they just tracked the returns of a major index, says Joe Gordon, the founder and managing partner of Gordon Asset Management, a wealth advisory firm in Durham, N.C.
Continued: Does it limit the single-stock risk?
