ETFs: Beyond the Hype

Exchange-Traded Funds

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend
Subscribe

On ETFs

ETFs: Beyond the Hype
Michael Iachini
CFA, CFP®, Director, Investment Manager Research, Charles Schwab Investment Advisory
August 17, 2009

Key points

ETFs are not for everyone. Before you leap, consider what they are—and whether they're really right for you.
Look at situations where mutual funds might be a better option.
Ideas for ETFs and mutual funds to consider.

It's hard to flip through a financial publication without being bombarded by ads for exchange-traded funds. But despite all the hype, ETFs are not for everyone. Before you leap, consider what they are—and whether they're really right for you.

What's an ETF?
ETFs are basically index mutual funds that trade like stocks. When you buy an ETF, you own a single security that represents a basket of other securities, generally tracks an index and fluctuates with the value of the underlying assets.

But there are key differences: The biggest is how you make your investment.

With an ETF, you place an order to buy or sell shares just as with any other stock—and you pay a commission on that trade. This means you can buy an ETF at its current price anytime during the trading day.

In contrast, you can only buy an index fund at the closing price.

ETFs also tend to be more tax-efficient than index funds.

One example is the oldest ETF, the S&P 500 Depositary Receipt (SPY). Often abbreviated as SPDR and pronounced "spider," it only made capital gains distributions in two of its 15 years of existence.

How did the largest three S&P 500® index funds distribute capital gains during that same 15-year time period? Vanguard made capital gains distributions in five of those years. Fidelity and T. Rowe Price each made capital gains distributions in seven of those years.

Another potential advantage of ETFs is that they are not required to keep return-dampening cash on hand for redemptions, unlike mutual funds.

When are ETFs right for you?
Here are smart ways you might use ETFs in your portfolio:

Investing a large amount of cash in an index. If you're looking to make a big long-term investment, you might consider a low-cost, broad-market ETF like the iShares Russell 3000 Index (IWV), which has an expense ratio of just 0.20%. Though there's a commission, the low expenses allow you to recoup these costs, particularly on a large investment.
Getting exposure to a sector or asset class at a relatively low cost. If you're building a diversified portfolio of stocks or mutual funds, ETFs can help you fill in the gaps or cheaply implement a tactical asset allocation. For instance, if you want health care exposure, consider the Health Care SPDR (XLV), which tracks the S&P 500 health care sector.
Putting excess cash to work. Institutional investors use ETFs to "equitize" their cash—to put excess cash into stocks that can be converted back easily. Putting cash into an ETF like the iShares S&P 500 Index (IVV) may make sense while you wait for an attractive investment opportunity. ETFs don't have short-term redemption fees like many no-load funds (though commissions may still apply).

When might mutual funds be better?
Here are situations where ETFs might not be the best option:

Investing small amounts of money at a time. If you're investing a small amount of cash, an index fund is a better choice than an ETF simply because of commissions—the downside to the stocklike nature of ETFs. With a Schwab OneSource® mutual fund, it costs you nothing to deposit more cash into the fund, but with an ETF, you have to pay a commission every time you buy or sell.
Seeking an index-beating return. If you're searching for a manager who can find hidden gems and deliver better returns than an index, you might not want to look to an ETF. Nearly all ETFs aim to match an index, meaning you'll get the index return less expenses, never more. A good actively managed mutual fund may be able to outperform the market. While there are some active and quasi-active ETFs, there are far more options among mutual funds.
Investing in certain categories. Although the number of ETFs is growing, there are currently fewer than 1,000 ETFs but more than 10,000 mutual funds. There are still very few ETFs that invest in foreign small-cap stocks, municipal bonds, and blended portfolios of stocks and bonds. For investments like these, consider high-quality mutual funds.

ETFs and Mutual Funds to Consider

Morningstar category	ETFs	Mutual funds
Large-cap blend	iShares S&P 500 Index (IVV) iShares Russell 3000 Index (IWV)	Schwab S&P 500 Index Fund (SWPPX) Schwab Total Stock Market Index Fund® (SWTSX)
Small-cap blend	iShares Russell 2000 Index (IWM)	Schwab Small-Cap Index Fund® (SWSSX)
Specialty—health	Health Care Select Sector SPDR (XLV)	Schwab Health Care Fund (SWHFX)¹
Foreign large-cap blend	iShares MSCI EAFE Index (EFA)	Dreyfus International Stock Index (DIISX) Schwab International Index Fund® (SWISX)
Diversified emerging markets	Vanguard Emerging Markets (VWO)	Lazard Emerging Markets Open (LZOEX)¹
Intermediate-term bond	iShares Lehman Aggregate Bond (AGG)	Dreyfus Bond Market Index Inv (DBIRX)

A Schwab consultant can help you decide whether ETFs make sense for you, or you can get started with the ETF Visual Screener and other ETF resources on Schwab.com. If you're not yet a Schwab client but would like to learn more, call 800-435-4000 to get started.

1. Actively managed fund.

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.

Past performance is no guarantee of future results, and the value of your account will fluctuate on a day-to-day basis depending on shifting market conditions.

Exchange-traded funds 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.

Charles Schwab & Co., Inc., member SIPC, receives remuneration from fund companies participating in the Mutual Fund OneSource® service for record keeping and shareholder services and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(0809-10254)

Return to Top

Related Resources

Most Recent

See all Exchange-Traded Funds

Subscribe to Liz Ann Sonders

Receive Schwab's latest market analysis via email:

Sonders on Strategy
Schwab Market Perspective
Schwab Sector Views

Take action

Learn more about ETFs
Clients can log in to our ETF center

Learn more about this topic