Advantage #3: ETFs are more tax efficient than regular index funds. Traditional index funds are quite tax efficient by their very nature because they rarely sell stocks from their portfolio (which triggers capital gains). In addition to sharing this natural benefit of indexing, ETFs also avoid the possibility of having to sell stocks from their portfolio to meet redemption requests. When ETF owners want to sell, they do so on the open market with other buyers and sellers, so there's no need for any stocks in the underlying portfolio to be sold to raise money, even in the face of heavy selling pressure. ETF tax advantages are more than just theoretical—in the past they've made smaller distributions to shareholders than comparable index funds, holding down taxes for their investors. However, the actual dollar difference of this advantage is quite small for most investors, and really only becomes a significant savings when investing six-figure sums.

While there's much to like about ETFs, they aren't without disadvantages. Here are two major ones to consider.

Disadvantage #1: ETF's trade like individual stocks. The first advantage of ETFs turns out to also be a primary disadvantage. While the flexibility of buying and selling anytime sounds like a plus, it's actually a mixed bag. Trading continuously on the open market complicates things, diminishing one of the chief virtues of indexing—simplicity. Buyers of index funds know that everyone buying that day gets the same price, calculated based on the value of the underlying stocks at the end of the day. Not so with ETFs, where you pay a market price rather than one based on the value of the stocks owned by the portfolio. In addition to that possible premium, paying the "spread," or difference in price between what buyers are offering and what sellers will accept, will cost you as well, especially on ETFs that are thinly traded. Which leads conveniently to...

Disadvantage #2: ETFs are expensive to buy and sell. Whereas buying an index fund is typically free (if investing directly with the fund company), ETFs are bought like stocks. In other words, you make your trades through a broker, which means paying a trading commission every time you buy or sell. This makes ETFs a horrible way to invest for anyone making regular investments to their portfolio. For most individual indexers, this disadvantage alone makes ETFs a very unattractive proposition. Even if you only do infrequent rebalancing, this commission cost can outweigh the advantages of ETFs and tip the balance towards using traditional index funds.

Noteworthy by its absence from our discussion is another kind of cost—the expense ratio. For a long time, the cost advantages of ETFs were loudly trumpeted as a major advantage. And for institutions with hundreds of millions of dollars to invest, even a small difference in expenses can indeed be a major part of the calculation. But for individuals, the differences in expenses between traditional index funds and ETFs have always appeared more significant on paper than they are in reality. For example, the largest ETF that tracks the S&P 500 index has an expense ratio of 0.12%. That's just two-thirds the 0.18% charged by Vanguard's 500 index fund. Sounds like a big difference! But for most of us it really isn't, amounting to just $6 per $10,000 invested. And now that Fidelity and Vanguard have made it easier to qualify for their Spartan and Admiral share classes, which carry expenses of 0.09% and 0.10% respectively, any difference in expenses between ETFs and the traditional index funds has become a non-factor. Most investors would pay far more in trading commissions buying their ETFs than they'd save in expenses.

To sum up, the primary advantages offered by ETFs are of greater value to institutions and high-dollar investors than most "regular folks." While ETFs get lots of media attention, individual investors are likely to find the old-fashioned index funds recommended in SMI's Just-the-Basics strategy both easier to use and more cost effective. That's a winning combination.  

Published March 18, 2009

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