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Don't Abuse the Benefits of ETFs

ETFs offer a number of benefits, but that does not mean we can ignore investing fundamentals.

Michael Rawson, CFA 16 June, 2010 | 0:00
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While ETFs offer many advantages over other investment vehicles, there are a number of situations in which these advantages can be eroded through the careless actions of the investor. In this article, we take a look at some ways ETFs are used that are counter to sound investing principles. We encourage investors to adopt the use of ETFs in certain circumstances, but do not think that adopting this investment vehicle allows you to abandon the time-tested principles of sound investing. If and when you decide that ETFs are right for you, be sure to take advantage of the resources Morningstar has to offer, such as the ETF analyst reports, to help you find the right product for your needs. 

Rapid Trading
Does the ability to trade ETFs on the market encourage high turnover? One of the disadvantages of mutual funds that inspired the idea of the ETF was the inability to trade at any point during the day. Mutual fund providers will trade with you at net asset value without charging a bid-ask spread or commission, but only once a day, after the market closes. Once-per-day trading discourages high frequency traders. In fact, some mutual funds even use redemption fees to discourage trading over periods as short as a few months. In contrast, you can trade ETFs as often as you desire--but do so at your own peril. Unlike with mutual funds, each time you trade an ETF you incur a commission charge from your broker, a bid-ask spread cost, and potentially higher tax costs. Perhaps more importantly, studies have shown that investors who trade more frequently earn lower returns. The return that an investor actually gets, rather than the buy and hold return, is a concept Morningstar measures through data called Investor Returns. The frequent trading of ETFs is a major reason for John Bogle's skepticism of the product. 

Most Efficient Vehicle?
While the ETF is quickly replacing the mutual fund for stock indexes, the same is not true for bond indexes. While the stock market is highly liquid and stock prices almost never go stale, this is not true in fixed-income markets. Bonds often trade infrequently, and transactions still are largely conducted over the telephone. Perhaps more importantly, the asymmetric return pattern on bonds demands proper diversification. With bonds, the maximum upside we can expect is capped at maturity as a bond will pay only par plus the coupon. But if the bond defaults, the downside can be 100%. Thus bonds returns exhibit a negative skew. Just one default could cause a bond portfolio to underperform. Whereas active stock fund managers prefer more nimble, smaller portfolios, bond fund managers require the economies of scale of larger funds. Thus smaller bond ETFs may not be able to reach the scale necessary to achieve diversification. This has not stopped ETF providers from offering ever more bond ETFs, where they slice and dice the bond market into narrower segments.  

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About Author

Michael Rawson, CFA  Michael Rawson, CFA is an ETF Analyst with Morningstar.

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