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ETF Education
Using ETFs in Your Portfolio
| What exchange-traded funds can add to your mix. |
| by Sue Stevens, 11/29/01 |
| Newly retired Jack Collins still has work to do. On his investment portfolio, that is. The 57-year old former operations manager is trying to reduce his position in his former employer's stock and add diversity to his portfolio. (Because of tax issues, Jack can only sell about $25,000 of the stock per year.) |
| "I am proposing using iShares for my core position in large-cap, mid-cap, and small-cap," says Jack. "Everything I've read supports using this type of product. What do you think?" |
| Here's how I (and other financial planners) think exchange-traded funds (ETFs) can help some of our clients. |
| What We Know About ETFs |
| Like index funds, ETFs track an index; managers aren't actively choosing stocks (so far). ETFs trade like stocks and usually carry low expenses. |
| ETFs seem to be more than a passing fad. That's why Morningstar.com has an entire section devoted to ETFs. In fact, senior analyst Chris Traulsen has written an excellent article covering all the basics that anyone comtemplating ETFs should read "Exchange Traded Funds: What You Should Know." |
| The Pros... |
| I think ETFs offer investors some benefits. |
| Tax efficiency: When a mutual fund is faced with shareholder redemptions, it must sell underlying securities to raise the cash to pay shareholders. Any capital gains that are triggered by those transactions are passed on to the remaining shareholders. Because shareholders sell shares to others, ETFs don't have to sell underlying securities to meet redemptions. As their underlying benchmarks change, however, ETFs will have to pay out something. Distributions should happen less often than with traditional mutual funds, though. |
| Cost efficiency: Annual fees are often lower than they are for comparable mutual funds. |
| Flexible trading: You can trade at any time of the day. And unlike some tax-managed funds, you won't have to pay any back-end fees or penalties when you redeem. |
| No minimum investment. You just have to have enough money to cover the cost of buying a single share, plus the broker's commission. |
| Wide variety of asset classes. |
| True global product: ETFs can be bought and sold in any country in the world. |
| Style consistency: If you've structured your portfolio to allocate a certain percentage of assets to various styles and/or sectors of the market, you want your investment vehicles to remain "true" to their stated objective. By using ETFs that track a particular underlying market segment, you may be able to execute your strategy more effectively than if you rely on actively managed mutual funds. |
| Broadens the scope of investment options. |
| Can be bought at various prices throughout the day. Even though I'm NOT a fan of short-term trading, ETFs do allow you to purchase shares at varying prices throughout the day, which could be an advantage to short-term traders. |
| ... And Cons |
| The negatives of ETFs include: |
| Occasional unwanted distributions: Much to the disappointment of individual investors, some ETFs have distributed capital gains. For instance, Barclay's iShares S&P 500 Index paid out $0.07 per share last year due to short-term cash flow issues. Read more in "An Unexpected Tax Bite from Barclays' iShares". |
| Brokerage fees: Every time you buy or sell an ETF, you pay a brokerage commission. For some investors, these fees can offset the lower annual costs that ETFs usually charge. |
| Bid/ask spread issues: Because of the way that ETFs are structured, you could end up buying an ETF at a premium to the portfolio's value and selling at a discount. Although this is uncommon, it can happen--particularly in thinly traded international markets. And the more volatile the market is, the wider bid/ask spreads may become. |
| Liquidity, low trading volumes, settlement concerns: In less efficient markets, it may take time to match an ETF seller with a buyer. |
| UIT format: Some of the older ETFs are structured as unit investment trusts (UITs), and because of that they may have a "dividend cash drag." In UITs, dividends will be held in an interest-bearing account until the end of each quarter before reinvesting them in the account. In contrast, a mutual fund is able to reinvest dividends daily. The delay in reinvesting dividends in UITs can have a negative effect on total return. |
| May not replicate returns of underlying portfolio. Tracking error, management expenses, and liquidity of the market that the ETF invests in can lead to returns that don't match that of the market. It seems that even though this can also be a problem with mutual funds, the effect can be more pronounced in ETF products. For more on these concerns, go to efficientfrontier.com, Bill Bernstein's website. |
| How Planners Are Using ETFs |
| I spoke with Mark Balasa and Deena Katz, two of the most respected financial planners in the business. Both are using ETFs with their clients, primarily when they have new money to invest. Both also tend to limit the types of ETFs they use. Says Deena Katz: "We use the Russell 1000 Value IWD and iShares S&P 500 IVV primarily for tax efficiency, diversification, and their ability to track the underlying index." |
| Having seen many new investment vehicles come and go over the past 20 years, my advice would be to use caution: You never know what can go wrong with a new investment vehicle. Don't put the majority of your portfolio in anything new. |
| My recommendation for Jack would be to start by investing in some of the diverse ETFs using vehicles like Barclay's iShares S&P 500. I would use this fund over something like Spiders SPY because the Barclay product is structured as a mutual fund whereas SPY (at least the SPDR Trust, Series 1 product) is structured as a UIT. |
| Continue to watch developments in ETF markets. More and more companies are getting in the ETF game. Vanguard's VIPERS have received SEC approval and are due out sometime in the first quarter of this year. |
| Add grad ually to ETFs in your portfolio. I would start with perhaps 5% to 10% of your core holdings in ETFs and not go any higher than 50% of your core. |
| Practical Advice For Improving Your Portfolio |
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