Exchange-Traded Funds (ETFs) are funds that have the characteristics of mutual funds but trade like stocks on a stock exchange. 

They are an easy to use, low-cost and tax-efficient way to invest your money. ETFs can be used to construct a well-diversified and tax-efficient portfolio. We own several as part of our core holdings in client accounts. They also offer hedging opportunities and allow for the targeting of specific market sectors.

For example, we’ve used them to successfully hedge client portfolios before and during the market meltdown of 2008. Recently, we used them in an opportunistic manner when we purchased two insurance sector ETFs, which were beaten down in anticipation of widespread destruction from the major Hurricanes.

Here's why you may want to include them in your portfolio:

1. ETFs have low costs

The average ETF is typically 1/3 the price of a typical mutual fund. Core ETFs that track the major indices cost about 1/10th as much as the typical mutual fund and can help you build a strong foundation for your portfolio1.

A fund’s costs include, but are not limited to, portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution. ETF companies have a lower overhead, and much of that savings is passed on to individual investors in the form of lower fund expenses.

2. ETFs are tax-efficient

Due to structural differences, ETFs distribute capital gains less frequently than do comparable mutual funds. Capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas mutual funds pass on capital gains taxes to investors through the life of the investment.

When you sell your mutual fund or ETF at a gain, you will have to pay taxes on that gain. But capital gains taxes can be incurred even if you don’t sell your shares due to trading activity within your fund. ETFs typically have lower annual taxable distributions because they trade less frequently than mutual funds.

3. ETFs offer trading flexibility

Traditional open-end mutual fund shares are traded only once per day after the markets close. ETFs are bought and sold during the day when the markets are open.

The nearly instantaneous trading of ETF shares makes intraday management of a portfolio very efficient. You can easily move money between specific asset classes, such as stocks, bonds, or commodities.

4. ETFs are transparent

You can check the price of your ETF at any time. Unlike ETFs, mutual funds calculate their share price at the end of the day based on the net asset value. ETFs, unlike mutual funds, report their holdings on a daily basis, providing you with more details about your investment. ETFs generally have lower turnover than mutual funds – the underlying holdings of ETFs don’t change as much as those of a typical mutual fund.

Mutual funds are also subject to something called “style drift”. Managers have been known to chase performance, which is often counterproductive and can change the risk-return profile of the fund. For example, let’s say growth is outperforming value in any particular extended time period. The managers of value funds, consciously or not, may start adding more growth-oriented stocks to their portfolios in order to improve portfolio performance. Depending on what else they own, shareholders may become overweight in growth stocks and not even know it. By contrast, a value-stock ETF will hold value stocks no matter what.

5. ETFs can fill specialized niches in your portfolio

Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment.

They’re a great choice for tactical investing, or temporarily overweighting or underweighting asset classes based on forward-looking views of the market.

Bottom Line

ETFs give you low-cost access to just about every area of the market. They can help fill gaps in a diversified portfolio of stocks or mutual funds by enabling you to invest according to market sectors, characteristics, and/or geography.

You should consider using ETFs in taxable accounts, whenever passive investment strategies are appropriate. The combination of tax efficiency and low costs offer significant advantages over similarly managed mutual funds.

While some mutual funds still deserve a place in your portfolio, adding ETFs may help you build even more diversified holdings at a lower cost while giving you added flexibility. 

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1 BlackRock and Morningstar, as of 12/31/16. Comparison is between the average Prospectus Net Expense Ratio for the iShares Core Series ETFs (0.08%) and the average Prospectus Net Expense Ratio of active open-end mutual funds (1.17%) available in the U.S. on 12/31/16.

 

George Kiraly Jr., CFP®, MBA is a NAPFA-Registered Financial Advisor.

Disclosure: George Kiraly Jr., CFP®, MBA is the Founder & Chief Investment Officer of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. The above commentary does not constitute individual investment advice. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

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