Total investments in exchange-traded funds have topped $2.4 trillion as of September, more than double the $1.1 trillion at the end of 2011. ETFs have benefited from a shift away from actively managed mutual funds toward funds that passively track various investment indexes. However, in buying ETFs, which trade much like stocks on exchanges, many investors make false assumptions that cut into their returns. How to avoid these costly misconceptions…
Don’t assume that all ETFs carry very low fees. Highly specialized ETFs can be as expensive as or more expensive than actively managed funds. And even various similar ETFs can charge very different fees. Example: iShares US Technology ETF (IYW) and Technology Select Sector SPDR ETF (XLK) both track large-cap tech stocks. But IYW has an annual expense ratio of 0.44%, more than three times the 0.14% for XLK.
Don’t assume an ETF’s assets are spread broadly across its portfolio’s stocks. Even if an ETF portfolio includes many different names, its weightings might not provide much diversification. For instance, although the popular Energy Select Sector SPDR ETF (XLE) tracks all 36 energy companies in the Standard & Poor’s 500 stock index, its top three holdings—Exxon Mobil, Chevron and Schlumberger—account for 40% of its total assets. Such high concentration typically leads to much greater volatility in a fund.
Don’t ignore extra costs for trading ETFs. Just as with a stock, you typically must pay a brokerage commission ranging from $7.99 to $19.99 each time you buy or sell ETF shares. Smart: Trading in many in-house ETFs at Vanguard and Charles Schwab is commission-free for investors who open a brokerage account. And at Fidelity, account holders can trade 70 iShares ETFs commission-free.