Would the intern buy an ETF?

When Brooke and Elizabeth first handed me the assignment to write a basic story about an ETF, I didn’t tell them I only had a vague idea of what they were – like how I know how computer code is a series of 1s and 0s, but I have no idea how it actually works. 


Apparently I’m not alone. Roughly 60% of advisors invest in ETFs, according to Cogent Research.

Still a pretty low number, considering how ubiquitous ETFs have become – even ex-Law and Order actor, Sam Waterston, extols the benefits of commission-free ETFs in a recent commercial for TD Ameritrade. 

 https://www.youtube.com/watch?v=zZ2OL180Sxg. 

I’m sure those commercials have had a few more main street investors calling up their advisors, asking about these “exchange traded funds.”

As Brooke discovered in his reporting, the giants of the business are well aware that even many advisors are bewildered when it comes to choosing among 800 different ETFs in the construction of portfolios. They are offering more and more guidance to remove the complexity for advisors — and relying more on managed ETFs in reaching retail customers. See: How BlackRock plans to grow iShares using advisors as one key.



For my search to understand ETFs from an intern’s point of view, I read up before making my calls and writing out a few, I hoped, intelligent questions.

I learned a few things: 

ETFs, or exchange-traded funds, are a basket of investments that typically follows an index, but trades like a stock.

 Since ETFs trade like stocks, they are more liquid than mutual funds. ETFs can be bought and sold many times during the day. One caveat: The liquidity of an ETF is based on its underlying holdings, so investors need to evaluate the ETF based on what it contains – not how many shares it has.


So, an ETF makes it easier to get out of the position if an investor needs cash. But investors should view an ETF as a mutual fund and only get out when it’s absolutely necessary.

The liquidity may not be a great thing for the market, I learned as I read about the questions that still remain about the role ETFs played in the flash crash. The Securities and Exchange Commission report cited a large trade that precipitated the Dow’s 700-point decline. But “(ETFs) suffered a disproportionate number of broken trades relative to other securities,” the report said. Typically, ETFs represent 35% of daily trading volume. The percent on May 6 was nearly double that.

Phone calls


I then called a few professionals who were nice enough to take the time to help me understand how investors should evaluate ETFs. 

“People invest based on title,” says Paul Weisbruch, vice president of ETF sales and trading at Street One Financial, a registered broker dealer. “They see ‘NASDAQ 100’ and think that it must be good.”

The good (bad?) thing about being a graduate student is that I don’t have much money to invest.

 Still, the question was, if and when I did, could I understand an ETF well enough to invest in one?

To get beyond the name, investors should evaluate ETFs by costs, holdings, and investing needs. 

ETF costs are often lower than those of mutual funds because most ETFs passively track indexes. So, once an ETF is created, there’s no need to pay a fund manager to buy and sell securities.

“It’s basically a static index that’s transparent, where everyone knows what the holdings are,” says Tom Lydon, editor of ETFTrends.com and author of The ETF Trend Following Playbook.



For example, the Vanguard 500 Index Fund (VFINX) has an expense ratio of 18 basis points while iShares’ S&P 500 Index ETF (IVV) has a 9-basis-point expense ratio. The two funds have mirrored each other in performance in the last year – the IVV slightly outperformed VFINX by roughly a percentage point. So, even if investors never want to trade an ETF, it leaves more money in their portfolio.



ETF Investors also save on capital gains taxes. Every time an asset is sold within a mutual fund, investors pay capital gains taxes. For example, when an investor wants to exit a mutual fund, the fund manager has to sell a portion of the fund to pay out that investor. An investor’s return is reduced because he or she is paying taxes when the gain from the sale is realized. You don’t pay capital gains taxes on an ETF until it’s sold.


When evaluating an ETF, compare its expense ratio to that of others in the same category. For example, by visiting Vanguard’s site you’ll see Vanguard’s S&P 500 (VOO) ETF is cheaper than 95 percent of funds with similar holdings, with a rock bottom expense ratio of just 6 basis points.


Price shouldn’t be the only factor in picking out an ETF. Be sure to look up what holdings an ETF has. Just because ETFs follow an index it doesn’t mean that they are diversified. A very popular ETF, PowerShares QQQQ, tracks technology stocks, but nearly 20% of its holdings is Apple Inc. Of course, if an investor wants that much exposure to Apple, then it might make for a great investment. But investors should know what kind of ETF they’re buying.



Drawbacks



A major drawback of ETFs is trading costs. Since ETFs are stocks, each time they’re traded investors rack up commission fees. These costs make ETFs less attractive when it comes to dollar cost averaging.

This problem might not last much longer. Brokers are starting to offer select commission-free ETFs. Charles Schwab waived fees on select Schwab ETFs, Fidelity partnered up with iShares, offering 25 commission-free iShare ETFs, Vanguard has started selling its own set of commission-free ETFs.



Late last year, TD Ameritrade started offering more than 100 commission-free ETFs from different providers. By not aligning with a specific provider, TD Ameritrade has opened ETFs to commission-weary investors. Other brokers may follow, leading to a possible price war against mutual funds. See: Relentless TD Ameritrade antes up a killer ETF platform.

The fees are the bottom line

The big question for clients and advisors is, once they understand ETFs, will they invest in them. Here’s what I do if I had the cash: Invest in an ETF that tracks the S&P. I know I’ll pay close to nothing in fees and since my horizon is another 40 years, I’m content with the market return, rather than stressing out trying to beat it.

Matthew Robinson was the RIABiz intern last fall.