Investors have flocked to exchange-traded funds (ETFs) in recent years, seeking to save money and simplify their investing. In fact, in 2017, investors added about $400 billion to ETFs, which trade like stocks on exchanges, compared with less than $100 billion of net inflow to mutual funds. But many investors are confused about some of the benefits and drawbacks of ETF investing, leading them to make costly mistakes.
Here, investment expert Larry Swedroe pinpoints the biggest mistakes ETF investors make—and shares his techniques for using ETFs most effectively…
Mistake: Relying on an ETF’s name to tell you what you’re investing in. Most ETFs are “passive” funds set up to track certain indexes, not to “beat the market.” And many ETFs’ names include the names of the underlying indexes they track, such as the SPDR S&P 500 ETF.
But to stand out in an increasingly competitive industry, some ETFs have adopted misleading names that are better at attracting uninformed investors than accurately representing the funds’ strategies.
Example: iShares MSCI World ETF (URTH) sounds like a fund that invests around the world. But its 1,200 holdings exclude emerging-market countries, which are a significant portion of the global economy.
Lesson: It’s buyer beware when it comes to what an ETF decides to call itself. Look beyond the label to see what the fund actually holds and whether it meets your investment objectives.
Mistake: Assuming that various ETFs focused on the same area of the market will get similar results.
In fact, two such ETFs can produce very different levels of risk and performance depending on factors including the number of stocks they hold and how much of their assets they allocate to top holdings.
Example: If you want exposure to the technology sector, there are dozens of ETFs to choose from. The two with the most assets—Technology Select Sector SPDR Fund (XLK) and Vanguard Information Technology ETF (VGT)—seem interchangeable, having similar top 10 holdings. But the SPDR fund tracks the 72 tech stocks in the Standard & Poor’s 500 Index and invests 60% of the fund’s assets in its 10 largest holdings.
The Vanguard fund follows a more diversified MSCI index with more than 340 stocks, and it has just 53% of its assets in its top 10 holdings. Moreover, the SPDR fund has very few small- and mid-cap stocks, resulting in a much higher average market cap, compared with the stocks in the Vanguard fund, which keeps about 15% of its overall portfolio in smaller companies.
Result: The SPDR fund is likely to outperform when tech giants such as Facebook, Apple and Microsoft dominate. But over longer periods, the Vanguard fund’s exposure to smaller companies has produced better performance.
Lesson: Look at the long-term performance of various ETFs that sound as though they have a similar focus—instead of assuming that they perform similarly.
Mistake: Thinking all ETFs are “tax-efficient.” Many plain-vanilla ETFs are very tax-efficient, meaning that these funds don’t generate big tax bills for investors. These ETFs rarely sell their holdings, which means that the annual distributions from any capital gains are minimal. But for ETFs tracking indexes with more exotic strategies that generate frequent trading and turnover, the tax burden can be onerous.
Example: The SPDR S&P 500 ETF (SPY) and the SPDR Russell 1000 Momentum Focus ETF (ONEO), which tracks large-cap stocks with rapidly rising share prices, had similar returns over the past year, around 16.5%. But after accounting for taxable capital gains distributions, the Momentum ETF, with a 101% annual turnover of its portfolio, had an actual return of just 12.8%, compared with 13.3% for the S&P 500 ETF (annual turnover of 3%).
Lesson: ETFs with high turnover may be better suited for tax-deferred accounts. To get a clearer picture of the tax consequences of owning a particular ETF, including the impact of capital gains and dividends, click on the “Tax” tab for the fund at Morningstar.com and compare pretax and tax-adjusted returns over various periods.
Mistake: Believing that investing in small-cap or foreign stocks requires actively managed mutual funds rather than ETFs. Many investors think that active fund managers maintain an edge in areas of the market that get relatively little attention from Wall Street because they can spot stocks that are undervalued. But the data say otherwise. Fund managers in these areas rarely beat comparable ETFs over long periods. According to S&P Dow Jones Indices, over the past 15 years, 95.7% of US small-cap stock funds underperformed benchmark indexes such as the S&P Small Cap 600. The same is true for foreign stock funds, a category in which 91.6% of active managers trailed benchmark indexes such as the MSCI EAFE.
Here’s why: Even if active managers could identify undervalued stocks that most investors were missing, they faced much higher trading costs in less trafficked and illiquid areas of the stock market.
Also, actively managed funds typically need large research staffs to ferret out bargains, which raises the costs of operating the funds, as well as the expenses that investors pay.
Lesson: Don’t rule out using an ETF for small-cap and foreign stock investing.
Mistake: Investing in an ETF that isn’t going to survive. In 2017, more than 130 ETFs were shut down, including ones managed by well-known providers such as Pimco and State Street SPDR. When an ETF liquidates, it doesn’t mean that your shares become worthless—they’re typically worth an amount equal to the underlying value of the investments that the ETF owns. However, there are several downsides to consider. The fund might charge you termination fees. There might be a delay of a week or more in receiving your money after liquidation. You have to figure out where to reinvest the money. And in taxable accounts, you might owe capital-gain taxes far earlier than you expected.
Lesson: Know the signs that an ETF is vulnerable to failing. These include a small amount of assets (less than $50 million)…a short track record (less than three years)…and/or low share liquidity (an average trading volume of less than 50,000 shares a day).
Are You Still Paying to Buy and Sell ETFs?
Commissions on buying and selling shares of exchange-traded funds (ETFs) typically are $5 to $45 per transaction depending on whether you trade online or require assistance on the phone. That can add up to hundreds of dollars a year if you own a lot of ETFs and/or trade frequently. But many brokerages, eager to attract new customers and more assets from existing ones, now offer free trades for many of their in-house ETFs and for some ETFs from other providers.
The ETFs that qualify to be commission-free usually track major indexes of domestic and foreign stocks or bonds. They include the S&P 500 Index, the Barclay’s US Aggregate Bond Index and the MSCI EAFE Index. Starting in August, Vanguard offers about 1,800 ETFs traded online from various providers commission-free…Fidelity, 22 in-house ETFs and 70 iShares ETFs commission-free…Schwab, more than 200 ETFs from 15 providers commission-free including its own in-house lineup and ETFs from Pimco, PowerShares, State Street, SPDR and WisdomTree.