What's So Great About ETFs?

Several years ago, I started adding ETFs to my own portfolio. As the number of ETFs has grown, so has my personal use of them.

Don't get me wrong, I still own individual stocks and mutual funds, but an increasingly greater proportion of my portfolio is allocated to ETFs. The reason is that there are several advantages that make ETFs very attractive.

ETFs Are Less Expensive Than Mutual Funds

The majority of mutual funds are actively managed, which means investors not only have to pay for a fund manager, but also a staff of analysts.

These expenses hurt your return. This wouldn't be a problem if the performance was spectacular, but it's not. According to Standard & Poor's, 71.9% of actively managed large-cap funds underperform the S&P 500. So while there are some funds that are worth paying extra for (and the Zacks Mutual Fund Rank will help you find them), most aren't worth the high fees.

ETFs, conversely, track an index. There is no staff of research analysts because the fund manager's job is easy - replicate the index. This in turn lowers costs dramatically. And every cent you save on expenses is a penny more you make. Over the course of a lifetime, these savings can make a dramatic difference in your wealth.

ETFs Are Far More Tax Efficient

Ever wonder how mutual funds got their name? They're called "mutual" funds because they are a pool of shared investment dollars. When you buy shares of a mutual fund, you add your dollars to a pool of money for the fund manager to invest.

The upside is that you get access to professional money management for a pretty small investment. The downside, however, is that the IRS holds you responsible for every profit realized by the mutual fund.

In fact, it is very possible to see the value of the mutual fund drop and still owe capital gains taxes on your investment. Taxes are realized the second a fund manager sells a stock at a profit. Ouch!

ETFs have fewer transactions because they track an index. Other than rebalancing or changes to the index, no transactions are made. That means fewer taxable events.

Sounds good, huh? Well, it gets even better.

ETF managers can conduct value-in-kind transactions. This means they can trade shares with an agent and avoid taxable transactions completely.

For example, one of the ETFs I personally own is the Vanguard Large-Cap ETF (VV). When a change in the index that VV follows is made, the ETF manager has a list of people ("agents") he can contact to swap the stock(s). Since he is not technically selling the shares, no transaction is made and shareholders don't owe any taxes.

ETFs Are Transparent

ETFs trade like stocks. You buy and sell them just like stocks. This means you always know the price you are buying and selling at.

Plus, since ETFs track an index, you know what assets they are holding. There is nothing to hide, because an index is designed to track the performance of a benchmark, not beat it.

There is a term for this - transparency. More transparency is always better.

(Mutual funds lack transparency. This is partially because their value can only be determined at the end of the day and partially because fund managers don't want to tell competitors what stocks they are holding.)

ETFs Allow You to Hold Short Positions in an IRA

Yes, you read that correctly; you can short indexes in your retirement account by using ETFs. And, yes, it is completely legal.

How is this possible? Federal regulations allow you to buy any ETF you want. When you purchase an ETF, you are buying shares of a fund and are paying cash up front for it. Therefore, no margin is used and the transaction is completely legal.

The ETF, on the other hand, is not bound by the same rules that an IRA account is. Therefore, the ETF can go long or short.

Let me give you an example. The Short Dow30 ProShares (DOG), as the name implies, shorts the Dow Jones Industrial Average ($DJI). So, when you buy DOG, you are hoping the S&P 500 falls in value. From a regulatory standpoint - and this is key - you initiated a long position. You are hoping that DOG increases in value.

Remember, you are using cash to buy an ETF that you think will increase in value, meaning you are going long. The strategy that the ETF uses is not relevant.

ETFs Make It Easy to Invest in Commodities

Since ETFs can be bought and sold like stocks, it's real easy to invest in commodities - even with retirement accounts.

For example, say you want to invest in gold. You could deal with the hassles of buying and storing physical gold or you could simply buy shares in SPDR Gold (GLD), which invests directly in gold bullion.

Think oil is headed higher? Your options are to stop driving, learn how to trade futures, or just simply buy shares in PowerShares DB Oil (DBO).

And if you think commodities are heading lower, you can easily short commodity-based ETFs too with a regular (non-retirement) brokerage account. It really is that easy.

ETFs Can Help You Profit from Industry Trends

I saved the biggest advantage for last - ETFs allow you take advantage of industry trends.

How big an advantage are we talking about? Well, consider this - investing in the right industry gives you a 4-1 performance advantage over investing in the wrong industry. That's a big difference.

Often, when I write my weekly Industry Rank Analysis column, I see business trends that are driving up earnings estimates on several companies within the same industry. Now, you could buy some of the stocks within that industry group, or you could simply buy the entire industry with just a single ETF.

In other words, ETFs allow you to profit from the industry trend and diversify across several stocks at once. That's a win-win situation.

As I said at the beginning, I don't solely invest in ETFs, but I do allocate a significant portion of my portfolio to them. Given their advantages, it just makes a lot of sense to incorporate ETFs as part of a broader investment strategy.

Wishing you prosperity,
Charles Rotblut, CFA

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