Invest Intelligently in ETFs

September 13, 2012

Michael Iachini
CFA, CFP®, Managing Director of ETF Research, Charles Schwab Investment Advisory, Inc. 

Exchange-traded funds (ETFs) are all over the financial press, and many investors are excited to start using these versatile investments.

What is an ETF?

An ETF is essentially an index fund that trades like a stock. There are ETFs covering everything from broad stock indexes to individual commodities, and the number of funds has been growing dramatically in recent years—from fewer than 400 in early 2007 to nearly 1,200 in early 2012.

ETFs come in three varieties: traditional, niche and exotic

Traditional ETFs are what most investors have in mind when they think of ETFs.These are low-cost, tax-efficient funds (most with annual expenses of 0.35% or less) that provide access to a broad range of securities in an asset class such as large US stocks, small US stocks, international stocks, or investment-grade bonds.

Traditional ETFs are useful tools for inexpensively diversifying your portfolio, and they are available in all major asset classes.

Niche ETFs are similar to traditional ETFs except that they focus on a narrow slice of a broader asset class. Niche ETFs invest in individual sectors like health care, single countries like France, or narrow parts of the bond market like high-yield bonds. They tend to have somewhat higher expenses than traditional ETFs.

Niche ETFs can be useful for completing a well-diversified portfolio, providing access to a part of the market that you're not getting from your individual security holdings. However, it can be tempting to use niche ETFs for speculating on narrow market segments, which can be risky.

Exotic ETFs provide access to unusual asset classes or investment styles, typically at a premium price by ETF standards (annual expenses often over 0.75%). Exotic ETFs include commodities such as gold, concepts such as clean technology, or leveraged securities that move twice as much as the market or directly opposite the market.

Although exotic ETFs might seem exciting, it is important to make sure that you fully understand the nature of the fund before investing, as exotic ETFs tend to be very different and often more volatile than traditional investments.

ETFs trade like stocks

Typically, when you own an ETF, just as with an index mutual fund, you own a single investment vehicle that represents a basket of other securities, tracks an index, and moves with the value of the underlying investments.

The main difference between an ETF and an index fund is the way you buy and sell shares.

With a mutual fund, your order to buy or sell shares is processed at the end of the day, and if you're investing in a no-load, no-transaction-fee fund there is no cost for the trade.

With an ETF, you can buy or sell shares at any time during the trading day, and you generally pay a commission just like any stock trade.

When ETFs are a good fit

ETFs can be useful investments, but it's important to know whether they're right for you.

Here are some guidelines for deciding whether to consider ETFs, and to help you understand when an ETF isn't the right fit.

If you're trying to get market returns and you're investing a large amount of money at one time, traditional ETFs might be a good choice because of their low cost and broad diversification.

However, ETFs may not fit well if you're trying to beat the market or if you're making small, regular investments.

• Buying an ETF means that you won't have the chance of performing any better than the market the ETF tracks, since you'll only get the returns of that market index (with the exception of the very few actively managed ETFs that currently exist). Conversely, an actively managed fund aims to beat its market (though it has the potential to lag that market). 
• Because you generally pay a commission for each ETF trade, small investments are usually better made in a no-load, no-transaction-fee mutual fund. That said, some ETFs are available commission-free at some brokerages—these ETFs may be suitable for small, regular investments.

If you're trying to round out your portfolio's asset allocation, a traditional or niche ETF could be a good fit.

If you generally like to pick individual stocks but you don't know much about a certain sector or region, you could use an ETF to complement your stock allocation so that you're more broadly diversified.

Again, be sure to consider the cost of commissions and whether you want active management before choosing an ETF over a mutual fund.

When you're not sure what to buy

If you have some cash that you plan to invest in stocks but have not yet decided what stocks to buy, you could use an ETF to "equitize" the cash—that is, keep it invested in the market without incurring the higher potential risks of a specific security.

Because there are no redemption fees on ETFs, there is no penalty for holding an ETF for a short time before selling it and then reinvesting elsewhere—though of course for most ETFs commissions apply to each transaction.

Smart investors love diversification and low costs, and ETFs have a well-deserved reputation for both. Not all ETFs are alike, however, and they're not right for every portfolio. With these facts about ETFs in hand, you can intelligently decide what role ETFs might play in helping you to reach your financial goals.