ETF Trap? Part 2

Here’s a follow up to my last article on ETFs. Chuck Jaffe of Marketwatch.com makes some of the same points I was trying to make in my article but he’s much better at it, afterall he does that for a living.

In my original post I wrote “Speaking of fees. The whole lure of mutual funds, specifically no-load or index funds, is the low fees. Buying or selling a stock or in this case an ETF triggers a commission. If you do your homework, however, you can buy mutual funds without a commission.” Why do you pay a commission on ETFs? Because they are treated just like stocks so whatever commission you pay to buy or sell GE, you’ll pay to buy or sell an ETF.

Chuck Jaffe writes: “The biggest drawback to ETFs for many investors is the simple fact that they must be purchased through a broker. Mike D. didn't say if he was shifting a well-built portfolio or building one for the first time, but the difference is crucial; an investor who has a big chunk of money to invest can do it all at once and incur one commission, while someone who invests regularly will pay the freight with every small step they make.

"Even with the low fees charged by online and discount brokers these days, the charges alone make ETFs the wrong choice for the investor who is setting aside money every month or quarter."

This is why generic advice such as "ETFs are better than index funds" or "Technology stocks are a good investment" aren’t worth much. Each individual has different needs. Doing research, learning about the different options out there is important but applying the lessons learned to your specific needs is the difference between success and failure.

Again from the Jaffe article: Says Brewer: "It's not as easy as saying 'This is better.' You have to look at them both and decide 'Which is best for me?'"

People may read that ETFs are just like index funds in their tax efficiency but that alone isn’t a reason to buy them if you’re going to trade it like a stock.

"What you save in tax efficiency and in the expense ratio, you lose -- and then some -- with every trade you make," says Gregg Brewer, director of mutual fund resources at Value Line. "If you have a lot of money to move, like in an IRA rollover, an ETF might be the right choice, but if you are dollar-cost averaging trying to get to where you have a lot of money, the traditional fund will be the way to go."

One of the things I don’t like about mutual funds is that I can’t buy at the exact moment I choose. If I choose to buy when the market is dropping, I would place the order some time during the day but it will be priced at the end of the day. So if the market stages a rally in the last hour of trading, I actually bought the fund for a higher price than the previous day. But beware of the lure that instant pricing of an ETF offers.

"Finally, the flexibility that some people find as a positive of ETFs also can be a negative, if it leads to quick trades. The savvy traditional index fund investor is playing a buy-and-hold game; the ETF investor buying a thin sector or taking a flyer on the stock market in Malaysia -- or even delving into the Qubes -- tends to be making short-term, market-timing decisions.

"For many people, it's like buying a sports car because it's good-looking and saying you never intend to break the speed limit. Eventually, most drivers will want to see what the car can do. Likewise, an investor knowing that the ETF can be traded on a moment's notice may pull the trigger on a trade when the market is having a bad day."