If investing were a high school popularity contest, exchange-traded funds would be homecoming queen, with financial advisors among their most avid supporters. In a study by the Financial Planning Association, 88 percent of financial advisors polled say they recommend ETFs to their clients. That compares with 80 percent who recommend mutual funds and 61 percent who steer clients toward individual stocks.
The appeal of ETFs rests largely with three key benefits, says Brooklynn Chandler Willy, president and chief executive officer of San Antonio-based Texas Financial Advisory. First, they typically have lower costs and fees than mutual funds. In 2016, the average equity mutual fund expense ratio was 0.63 percent, compared to 0.23 percent for the average equity ETF. That can make a substantial difference in how much of your portfolio’s growth you retain over time.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
A second benefit lies in the ability to trade ETFs throughout the day like a common stock, giving you more flexibility than a traditional mutual fund, and an ETF rates better for liquidity. The third benefit is that you don’t need a money manager to explain how an ETF invests. “You don’t have to read through a proxy or dig through the fine print to figure out what they mean,” Willy says. “With ETFs, you know what’s in it — they’re transparent.”
The move toward ETFs among advisors also reflects a shift in thinking. According to the Financial Planning Association survey, 77 percent of advisors believe that a combination of active and passive management can deliver the best investment performance. That’s a 20 percent increase in the number of advisors who shared that belief three years ago.
ETFs primarily rely on passive strategies to track a specific market index; they don’t try to beat the market. The goal instead is to create diversification and reduce risk while delivering consistent performance. Here’s what else you should consider before adding ETFs to your portfolio.
Are you in it for the short or long term? ETFs give investors the best of both worlds because they trade like stocks. “The investor chooses when they want to trade and can take advantage of how the market’s doing in real time,” Willy says. That’s an advantage because they’re able to be proactive on the downside and protect their investments, a feature that some investors especially may find attractive.
“If you’re a trader, ETFs are probably appealing to you because of your ability to own market segments very conveniently and efficiently,” says Christian Magoon, CEO of Amplify ETFs in Wheaton, Illinois. Instead of buying 35 stocks individually, you can buy one ETF that holds them all.
You do, however, need to consider the bid-ask spread or the amount by which an ETF’s asking price exceeds its bid price . Magoon says investors often zero in on the expense ratio alone. If you’re trading frequently, the bid-ask spread can affect your returns more than the expense ratio.
Ideally, ETFs should be owned for the long term. “If you’re an investor, think of your ETF like a bar of soap — the more you touch it, the smaller it’s going to get because you’re paying fees to trade the ETF and transaction costs,” Magoon says.
Adam Grealish, senior investment researcher for online financial advisor Betterment, says ETF investors should consider the total annual cost of ownership. That includes any annual fees, such as expense ratios, as well as annualized trading costs, like commissions and the bid-ask spread. This can give you a more comprehensive idea of whether ETFs suit your investing style and objectives.
How much volatility can you stomach? ETFs tend to offer more diversification than individual stocks or mutual funds but are not immune to volatility. That’s important to know if you choose ETFs based on your risk tolerance.
[See: 9 Dividend ETFs for Reliable Retirement Income.]
Because most ETFs are designed to match the returns of a benchmark index, the nature of the index becomes paramount, says Jamie Ebersole, a chartered financial analyst with Ebersole Financial in Wellesley Hills, Massachusetts. “To understand the volatility of an ETF, you need to look at the volatility of the index and determine how closely the ETF holdings match the index it’s following.”
Some ETFs increase their exposure to an index using leverage, which can heighten the volatility. Although these ETFs can produce higher returns, they can also be extremely unpredictable, making them a poor choice if you’re more risk-averse.
If you’re unsure how to gauge an ETF’s volatility, traditional metrics like standard deviation or the upside-downside capture ratio, which measures the possibility of gains to losses, are good places to begin, says Sean O’Hara, president of Pacer ETFs in Paoli, Pennsylvania. This information is found on most ETF fact sheets and can help you gauge overall risk. To get a truer idea of how volatile an ETF may be, “consider the ETF’s construction, how it weights equities and what names it excludes or includes in the fund,” O’Hara says.
It’s also helpful to consider the fund’s returns over the last decade to see how comfortable you’d be riding out highs and lows, Magoon says. Investors should look at returns for an ETF’s worst years and ask themselves if they could tolerate such a drop without panicking. You don’t want to fall into the trap of selling low and buying high.
Should you buy all at once or invest steadily over time? For every investing expert who believes dollar-cost averaging is the best way to invest, there’s another who advocates lump sum investments. With ETFs, you can do either one, but which is better?
For Magoon, buying into an ETF all at once is riskier than if you buy steadily over a period of months using a strategy known as dollar-cost averaging. The risk goes both ways, as “you could buy at a peak and end up feeling like you bought too high, or buy at a low and end up having a substantial return just because of your timing.”
[See: 7 ETFs to Trade Like a Hedge Fund.]
But investing a lump sum today has one significant advantage over dollar-cost averaging tomorrow. “If you’re planning to invest for any reasonable length of time, dollar-cost averaging just delays the time your money is in the market working for you,” Grealish says. If you have a longer investing window, a lump sum could work in your favor because “successful investing is more about time in the market than timing the market.”
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