5 Myths About ETFs

Michael Iachini
CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory
August 14, 2009

Key points

Here are five commonly held myths of ETF investing and why it pays to look beyond your first assumptions.
Consider carefully what it is you're looking for from an ETF before you buy—and make sure your ETF delivers what you need.
Find out whether ETF investing is right for your portfolio needs.

By now, you probably know a thing or two about exchange-traded funds, better known as ETFs. You know that ETFs are basically index mutual funds that trade like stocks. You know that they have low expenses and are easy to trade. You know that they are a cheap, easy, tax-efficient way to get good diversification.

Or you think you know all of that.

In fact, many ETFs may not have all of the good characteristics that you associate with this increasingly popular investment type:

Many ETFs have higher expenses than you might expect.
Some ETFs can be difficult and expensive to trade.
Rather than traditional indexing, some ETFs flirt very openly with active management.
Some ETFs can give you taxable income.
Certain ETFs give you no diversification at all.

Here are five commonly held myths of ETF investing and why it pays to look beyond your first assumptions.

Myth No. 1: All ETFs have low expenses
The first thing that many investors think about when they consider the good qualities of ETFs is the low expenses they carry. This is true for many traditional ETFs, such as the S&P 500 SPDR (SPY), which tracks the S&P 500® index and carries a tiny expense ratio of 0.09%.

But did you know that some ETFs charge much more? For instance, most ETFs that track single-country indexes—such as the iShares for the United Kingdom (EWU), Australia (EWA) and Germany (EWG)—charge 0.52%.

You'll also tend to pay more for funds that are focused on a specific industry, such as the iShares Dow Jones U.S. Oil and Gas ETF (IEO), which charges 0.48%.

Another example: ETFs that follow unconventional indexes, such as WisdomTree DEFA High-Yielding Equity ETF (DTH), which charges 0.58% and weights stocks according to fundamentals like earnings, dividends and cash flow.

ETF expenses currently top out at 1.53% with Claymore/Ocean Tomo Growth (OTR), an ETF that aims to invest in companies that own valuable patents.

The expenses might be worthwhile if you need the specific exposure the ETFs provide, and they are still generally less expensive than many actively managed mutual funds. But be aware: The fact that something is an ETF doesn't necessarily mean it's the cheapest option.

If you're trying to compare expenses between an ETF and a mutual fund, the expense ratio is a good place to start.

Clients can screen by expense ratios in the ETF Visual Screener on Schwab.com. ETFs will also have a transaction fee that you pay when you buy or sell—just like when you trade a stock. Mutual funds may have a transaction fee, as well as a sales charge (or load). For more information on mutual fund expenses, read Watch Out for Fund Expenses.

Myth No. 2: All ETFs are easy and cheap to trade
Investors also love ETFs because of their liquidity—the ease with which they can be bought and sold. It's true that you can trade ETFs anytime during the day, just like a stock.

But there's a cost to trading, and it's not just commissions. Whenever you buy or sell anything on an exchange, there's a bid-ask spread—the difference between the higher price at which investors are asking to sell and the lower price at which they're offering to buy.

For ETFs that are actively traded all day long, the bid-ask spread tends to be quite small. But less-liquid ETFs (that is, those that are harder to trade) tend to have much larger spreads.

In addition, unlike open-end mutual funds, the price of an ETF doesn't necessarily match the net asset value (NAV) of the securities in its portfolio. The difference is known as the discount or premium to NAV, and it can be very unpredictable.

More-liquid ETFs tend to have smaller discounts and premiums. So while you can trade an illiquid ETF anytime, it might cost more in spreads.

For example, one lesser-known ETF, Claymore/Zacks Country Rotation ETF (CRO)—which tracks an index of international stocks that changes its country focus over time— had an average daily trading volume for the month of July 2009 of only $15,000 per day, with no volume at all on eight of the 22 trading days in the month.

During the same period, the widely traded S&P 500 SPDR (SPY) had an average daily volume of more than $18 billion—over one million times that of the lesser-known fund.

According to data from XTF, the average bid-ask spread for the less-liquid CRO fund during this period was 1.66% of the price of the fund. During the same period, the average bid-ask spread for the ultra-liquid SPY fund was only 0.01%.

If you had accepted the price the market had set each time you traded, it could have cost you 1.66% of your investment to trade CRO but only 0.01% to trade SPY.

Not all ETFs are alike in liquidity. You can identify more- or less-liquid ETFs by looking at their 10-day volume in the ETF Visual Screener on Schwab.com.

Myth No. 3: All ETFs are index funds
You may like ETFs because they're index funds. With an index fund, you get all of the stocks in the index without having to worry about whether the portfolio manager is picking the right securities or not—the manager just buys them all.

However, not all indexes tracked by ETFs are traditional market indexes like the S&P 500.

Some indexes, like the PowerShares Intellidex indexes, are effectively actively managed; the company that puts the index together tries to include only stocks that it believes will outperform the market. And a few truly actively managed ETFs have been launched recently, such as Grail American Beacon Large Cap Value ETF (GVT).

This leaves you open to the possibility that the people or companies assembling the index will be wrong about which stocks will outperform. That's called active management risk, and avoiding that risk is one of the features of indexing that some ETFs fail to provide.

For example, the PowerShares Dynamic Market ETF (PWC), which is a total-market fund (meaning it includes very small to very large companies), has outperformed the total-market Russell 3000® index (which follows the 3,000 largest public US companies) by as much as 2.9% in a single month since its June 2003 launch—but it has also underperformed that index by as much as 4.2% in a single month.

Contrast this with a traditional total-market index ETF, the iShares Russell 3000 Index (IWV), whose returns have been within 0.05% of the index every month in that time period. While the more active fund may outperform a traditional index, the risk of underperforming is present, as well.

One way to tell if you're getting an actively managed fund in disguise is to read the language in the ETF's prospectus describing the index the fund is following. If the index picks stocks that are "expected to outperform," investigate further.

Myth No. 4: All ETFs are tax-efficient
Much has been made of the tax-efficient nature of ETFs, and it's true that they are often more tax-efficient than similar mutual funds.

The main reason for this is that ETFs usually will not be forced to distribute capital gains to shareholders thanks to the way ETF shares are created and redeemed. This means that you will typically only realize a capital gain if you sell your ETF shares for a profit.

However, just because a fund is an ETF does not mean that you will avoid all taxes as long as you hold it. Many ETFs still pay out dividends and interest to shareholders, and these payouts are taxable.

ETFs that invest in real estate investment trusts (REITs), such as the Dow Jones Wilshire REIT ETF (RWR), generally pay out dividends that are treated as ordinary income and are usually taxed at a higher rate than other dividends.

Interest from fixed income ETFs, such as the iShares Barclays Capital Aggregate Bond (AGG), is also typically taxable as ordinary income. On the other hand, ETFs that pay a lot of dividends, such as SPDR S&P Dividend (SDY), will generate taxable dividend income, most (but not necessarily all) of which will be taxed at the lower dividend rate.

Clients can use the ETF Visual Screener on Schwab.com to identify ETFs with high distribution yields, which can be an indicator of future tax implications.

Myth No. 5: All ETFs give you diversification
Finally, you may like the easy diversification provided by an ETF—by making one trade, you suddenly have a well-diversified domestic equity portfolio. This is certainly true for many ETFs. For instance, by buying one share of the iShares Russell 3000 Index (IWV), you gain exposure to nearly all stocks in the US markets.

This isn't true of all ETFs, though. Very narrow ETFs may provide you with very little diversification. iShares Dow Jones US Energy (IYE) looks diversified with 76 holdings, until you realize that more than half of its assets are concentrated in just five stocks! Buying shares of a gold (IAU, GLD) or silver (SLV) ETF gives you access to exactly one asset.

Generally speaking, the more narrowly defined the index, the less diversification it gives you. You can find the percentage of a fund concentrated in its top 10 holdings in the ETF Visual Screener on Schwab.com.

Myths debunked
Now you understand that not all ETFs are alike. Although many ETFs are good tools for providing inexpensive, highly liquid, tax-efficient diversification without taking on active management risk, some ETFs fail to live up to this billing.

Consider carefully what it is you're looking for from an ETF before you buy—and make sure your ETF delivers what you need. Visit the Schwab ETF Research Center on Schwab.com to research and select exchange-traded funds for your portfolio.

Low-cost ETFs to consider
Fund (ticker)	Index tracked	Fund category	Operating expense ratio
S&P 500 SPDR (SPY)	Large blend	S&P 500® index	0.09%
iShares Russell 3000 Index (IWV)	Large blend	Russell 3000® index	0.20%
iShares Russell 2000 Index (IWM)	Small blend	Russell 2000® index	0.20%
iShares MSCI EAFE Index (EFA)	Foreign large blend	MSCI EAFE® index	0.34%
Vanguard Emerging Markets (VWO)	Diversified emerging markets	MSCI Emerging Markets	0.25%
iShares Lehman Aggregate Bond (AGG)	Intermediate-term bond	Lehman Brothers Aggregate Bond Index	0.20%
Data from Morningstar® as of July 31, 2009.

Find out whether ETF investing is right for your portfolio needs. If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Exchange-traded funds (ETFs) are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Due to the limited focus of ETFs that focus on certain sectors, they may experience greater volatility than funds with a broader investment strategy. These types of ETFs are not intended to serve as a complete investment program by themselves.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

All charts and research have been compiled from publicly available, proprietary and/or licensed data.

Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Sector investing may involve a greater degree of risk than an investment with broader diversification.

International investments are subject to additional risks, such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

Small-cap stocks have historically been more volatile than the stocks of larger, more established companies.

Investing in real estate investment trusts (REITs) may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.

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