ETFs offer a number of potential benefits that can make them extremely effective for helping investors reach specific long-term goals, such as:
- Wide diversification in a single package. Contrary to much popular opinion, investors benefit from owning more stocks, not fewer. By including all the stocks in an asset class such as U.S. small-cap value, ETFs give that advantage to their shareholders. Studies show that owning more stocks will probably increase your return, and it will certainly reduce your level of risk.
- Low operating expenses. An ETF has no need to pay a staff of analysts to travel the world looking for exceptional “deals” or to hover over computer screens trying to figure out the economy. ETFs sometimes charge only one-tenth as much as actively managed funds in the same asset class. Those savings go to shareholders.
- Low internal trading expenses, because they simply don’t trade very often. Portfolio turnover is often overlooked by mutual fund investors, but the combination of commissions and spreads (the difference between bid and ask to buy and sell stocks) can cost as much as a full percentage point per year on top of operating expenses.
- Because of their lower turnover, ETFs reduce your tax exposure. Sometimes an actively managed fund can hit you with nasty, unexpected tax consequences. For example, a manager may sell a position in a stock the fund has owned for years, leaving shareholders with a large capital gain. In a taxable account, you are liable for your share of that tax even if you owned the fund for only a week.
- Full Transparency. When you buy an ETF, you know what you’re getting – the performance of an index. An active manager cannot do anything that easy and simple; he or she must do something different, and hope that it’s better than the index. Unfortunately for shareholders, very often, the opposite is true.
- Control of your exposure to the specific asset classes you want. In an actively managed fund, there is always the risk that a manager will acquire stocks that may seem attractive even though they don’t fit the fund’s intentions. Index funds also eliminate the risk of duplication, which can leave you owning several funds that all own the same stocks.
- Investors will most likely get above-average returns. Of course there is no guarantee, but if you buy an ETF and/or index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class.
- Less worry about monitoring the performance of an ETF manager. The manager’s only stock-picking role is strictly mechanical, to mirror what’s in the index. This is simple and inexpensive. And it’s very easy to compare your performance with that of its index; they should be extremely close.
- No or low transaction cost ETFs are easy to rebalance on schedule without worrying whether, by selling, you will miss out on a manager’s “hot streak.”
- Intraday liquidity or the ability to sell at any time during the day, if required, giving investors more flexibility.
- ETFs don’t keep your money idle in cash. It is not uncommon for actively managed funds to keep 2% to 10% of their portfolios in cash. One reason is to preserve buying power to purchase “hot” stocks; another is to cover redemptions of shareholders who want to bail out after market declines. That cash can cost shareholders 0.5% a year in return, with no corresponding benefit. This doesn’t happen in index funds.
- ETFs and Index funds put you in very good company. Index funds are favored by Nobel Prize winning economists, Warren Buffett, John Bogle, Charles Schwab, almost all academics, the largest U.S. pension funds, and almost every fiduciary adviser.
