Investing Tools: Exchange-Traded Funds (ETF’s) and Index Funds….the Rest of the Story

On his early morning show “Consumer Tips” on HLN today, financial guru Clark Howard commented that the highest number of “hits” he had on his financial advice advice website was in the category “Investment Guide.”  I can certainly believe that, financially-concerned reader; because even though it was never my intent to offer you a financial/investing advice blog, whenever I do decide to post something in this area of concern it seems to attract a substantial number of viewers.

And while I have at least a few times taken exception to something Clark has shared with people, today he featured something that any investor/saver should know about….but there’s more to the story.  He highlighted the usefulness of exchange-traded funds (most popularly and commonly known as “ETF’s).

I started using exchange-traded funds with a number of my old investment clients shortly after they “came out” as an investment tool.  It was the increasingly sophisticated and powerful ability of computers to make financial/market transactions that really made ETF’s possible.  To make it simple and understandable for my clients – many of them not being the “sophisticated” investors that Clark referred to this morning – I often used the metaphor of thinking of an ETF as a “basket” of common stocks or bonds/fixed income products of a particular type.

Let’s consider a hypothetical example.  An ETF of financial stocks might typically be an electronic “basket” of bank, brokerage firm, insurance company, or other such financial industry stocks.  How it works is this:  the creator/sponsor of the ETF (Barclay’s has been an especially well-known and successful source of ETF’s) creates the fund/”basket” by creating an electronic account into which it puts financial industry stocks it buys on the open market.  Much like the old, traditional mutual fund, Barclay’s (or whoever it is) starts selling shares of its ETF.

The stock market itself puts a value on those shares – the price of each share going up as people buy shares and trading pushes share price up….or share price going down if there seem to be more people interested in selling shares they had bought previously than there are people interested in buying those shares offered for sale.  Ultimately, the market price of ETF shares depends on how the market values the stocks that are held in the ETF “basket.”  If financial industry (banks, etc.) stocks are declining in market price….the ETF share price will pretty much inevitably decline as well.

The Financial Adviser/portfolio manager work is rather minimal – the ETF managers/traders simply buying those financial industry stocks that fall into the appropriate category of the fund….and then letting the market do it’s work.  And since it is so computer-enabled and driven, there is comparatively very little expense in “managing” the fund (there not being much research and management time and effort made in investment decisions).  So as Clark rightly pointed out, the expenses an investor pays to the ETF’s company are remarkably low – usually a small fraction of a per cent of the money invested, as opposed to a fairly typical 1.5% annually (besides sales “load” or costs) for the “active” management of the traditional stock mutual fund (which is not nearly as “active” or effective as the fund company would like you to believe).

Low expense in the buying and selling of ETF’s is tremendously attractive to investors/savers like you and me.  The primary reason that 80% or more of investment manager and mutual fund companies under-perform the markets is because of the fees they charge….dragging down their “performance” results by slicing off “their” part of the pie.

But another feature of ETF’s I really liked “from the get-go” is that they trade actively on the stock exchanges (hence the “exchange-traded” part) all day long – from the opening seconds of the market day to the closing time (most often 4:00 p.m. eastern time zone, Monday-Friday) – just like the shares of common stock that are held in the ETF’s basket.  What this means is that you know exactly what you are paying, or being paid, as you buy and sell!

This is opposed to those traditional mutual funds, again, where you have to put in a buy or sell order during the market hours….but it’s impossible to know what you will end up paying or receiving until after the markets close, and a “closing price” is determined.  If the fund share price was lower the previous day’s close – and thereby attractively priced in your judgment, so you decide to buy – but the market goes up the day you put in your order…the price you end up having to pay could well be substantially more than what you had wanted….all because you just can’t know what your price is until all closes the day you order.

So, lower costs, knowing the price you pay or receive when you buy or sell, more closely- related to the actual market conditions and performance….these are very useful “pro’s” in favor of ETF’s – and why I used them enthusiastically and in great preference to traditional mutual funds.  The latter I considered to be pretty poor tools for investing for most of my clients….too expensive especially (my own fees – including what had to go to the brokerage firm – were usually 33% or more lower than the annual fees of the mutual fund company, not counting those sales “loads” or costs).

But “the rest of the story” that Clark probably didn’t have time to go into is that there are some potential “cons” to ETF’s.  For one thing, not all of them are “equal.”  Some are better designed/set up than others.  That requires, then, at least some research/checking on the ETF history/performance record (and in the past that has been something of a problem, since their “newness” hasn’t provided much of a track record) and, preferably, just what it holds in its electronic “basket.”  If it is a financial industry ETF, do the market values of its stock holdings “track” the financial industry indexes so that it mirrors that sector with reasonable accuracy….or is it heavily weighted toward a more narrow part of the sector – like “big bank” stocks, but perhaps relatively ignoring the brokerages or insurance industry, for example?

And if it is a broad index of particular companies and their stocks that you are really seeking – such as the financial industry as a whole, or the famous S & P 500, for example – it might be worth your time and checking to look at a more traditional “index fund.”  (Without recommending or encouraging you in their direction at all, the long-established Vanguard 500 or Schwab 1000 are concrete examples, among others.)  Index funds are also low cost – you can easily compare those costs between index funds and ETF’s – and have much more of an easily-determined and established track record.  They do still have the mutual fund price drawback, however – when you buy or sell the index fund, you can’t know just what share price you will have to pay or settle for until the markets close the day you put in your order.

I still believe, prudent investing reader, that little beats finding and using a good, knowledgeable, skilled, highly-ethical Financial Adviser/broker who always seeks to put your interests, goals, needs, comfort-level with risk, and over-all benefit first…and is willing to do so at genuinely low cost to you (beware the financial professional who obviously is after the higher commissions and fees).

My good friend says – a bit cynically and previously “burned” – “Good luck finding such a person.”  But they are out there to be found.  And hopefully you can get an idea of that person’s track record as well….although probably something like 80% or so of brokers will also “under-perform” the markets in the results they help you achieve.  ETF’s and index funds are worth considering….thoughtfully and carefully, as always.

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