Refresh April 25, 2024 1:31 PM ET
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ETF Education
When ETFs Trump Funds
Are ETFs right for you?by Morningstar Analysts, 12/07/05
Dear Analyst,
In doing research for a class project, I've started to wonder whether mutual funds are worth all the fees and transaction costs. Although funds offer investors the benefits of diversification, so do investments like SPDRs. Should investors consider these ETF instruments instead of funds?
Amy C.
Hoping I'll do your homework for you, huh, Amy? I'll answer your question, but I hope you and everyone else will do your own investment research.
First I'll define SPDRs (pronounced "Spiders"). Then I'll investigate whether they're better or cheaper investments than mutual funds.
SPDRs, QQQQs, and Other Acronyms
SPDRs are members of a relatively new investment class called exchange-traded funds (ETFs). Simply defined, an ETF is a basket of securities that trades like an individual stock. ETFs thus combine the characteristics of funds and stocks: They own a variety of securities like funds, and you can buy and sell them throughout the day like an individual stock.
Most ETFs are similar to index mutual funds in that they invest in the holdings of a specific market index. SPDRs SPY, for example, track the Standard & Poor's 500. Qubes QQQQ, track the technology-heavy Nasdaq 100 Index.
Other ETFs, such as HOLDRs, are unmanaged stock portfolios sold in bulk by investment firms such as Merrill Lynch. Those securities target a specific sector or industry, and they can invest in far fewer stocks than mutual funds can.
Why Buy an ETF?
ETFs boast some advantages over mutual funds--but the biggest one is cost. SPDRs feature a low expense ratio of 0.11%. That's better than the cost of most index funds. That said, the difference between SPDR expenses and those of Vanguard 500 Index VFINX is small, 0.07 percentage points.
SPDRs and other ETFs do have one leg up on the otherwise excellent Vanguard fund, though. Funds, even index funds, must occasionally sell holdings if some of the fund shareholders sell their shares. This can trigger capital-gains taxes for remaining shareholders. ETFs, on the other hand, infrequently sell their own stock shares and don't cause big tax hits for their shareholders. So they could be more appealing to investors concerned with taxes.
For more on what ETFs have to offer, check out Exchange-Traded Funds: Are They Right For You? on Morningstar.com.
Where Funds Are Better
While ETFs are an exciting development in the investment world, they won't necessarily replace funds in the hearts of individual investors. For starters, they just don't cover the investment universe like funds do. There are nearly 200 ETFs and more on the way, but compare that with the nearly 18,000 mutual fund offerings available!
ETFs can also get very expensive if you trade frequently. As with stocks, you'll pay a commission every time you trade ETF shares. Therefore, those investing in small increments and hoping to take advantage of dollar-cost averaging will find ETFs too costly.
The Bottom Line
If you invest in a taxable account and intend to hold your investment for a long time, ETFs may be prudent, cost-effective investments. But frequent traders or people who want to buy gradually won't do themselves any favors by investing in ETFs.
