Investing in ETFs

Joel Dresang: Dave, exchange-traded funds are all the rage. They have about $2 trillion dollars of assets – 70% of that coming in the last 10 years. What are ETFs?

Dave Sandstrom: ETFs are an entity that owns assets. It could be stocks, bonds, commodities. Then they divide that ownership up into shares, and then sell those shares to investors.

Joel: So it sounds like these exchange-traded funds are very similar to mutual funds.

Dave: Well, they’re similar in the fact that it’s providing you with the diversity of owning multiple stocks or bonds within the fund, as opposed to holding individual securities. But, they’re quite different in how they trade. The ETF will trade throughout the trading day like a stock would. Whereas a mutual fund, you trade once a day and that price is then determined at the net asset value of the fund at the end of the trading day.

Joel: So, Dave, what’s the appeal? Why would an individual investor want to have an ETF?

Dave: Probably the most attractive for investors is the low cost associated with it. Most ETFs are passively managed, kind of like an index fund, and so it offers you some exposure to different markets at a very low cost.

The second one being, and this is maybe a little bit less of an advantage, but for some people who have large taxable accounts, there is some tax preferences to holding ETFs versus mutual funds in those accounts. Simply because of the way that the redemptions are handled gives you some relief from capital gains exposure.

Joel: What are some of the shortcomings that you see of ETFs?

Dave: Well, ETFs like other index funds, I think what you’re admitting right off the bat is, ‘I’m not interested in beating the market. I’m just going to take what it can give me.’

But more importantly is the downside risk. You’re signing up for 100% of the risk of that index. In a managed mutual fund situation, a good management team can provide you some protections against the downside and also give you the opportunity to possibly beat the index.

Joel: For long-term investors, is there a role that ETFs can play in their portfolios?

Dave: Certainly. I think that it’s some areas of the marketplace that aren’t as a compelling reason for stock picking. Large Cap Value might be one of those. I like broad exposure to the S&P 500, for example – at a low cost.

But I’m also interested in protecting myself on the downside and also having somebody at the helm of my mutual fund that is maybe steering us clear of trouble in the future or taking advantage of opportunities that you’re not going to get in an ETF.

Joel: And the difference between having a passive index fund and having an actively managed fund, that’s becoming more important as we’re seeing more of a divergence in how the market is performing.

Dave: You’re absolutely right, Joel. And I think part of the explosion of the popularity of ETFs over the last few years is because we’ve seen kind of a rising tide lift all boats – so all stocks doing very well.

We’re now starting to see that that’s no longer the case, and you need to be picking the right stocks at the right time.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Peter May
(initially posted Aug. 25, 2015)