Exchange-traded funds have become a major product in the investment world. In the following article, Paul Merriman tells what they are and helps you decide whether they are right for you.

At the most basic level, successful investing requires two things: owning the right assets and holding them in the least expensive and most efficient package.

I’ve already written extensively about what I believe are the best assets. In this article I want to talk about packaging.

Until the 1970s, the most common investment for individual investors was the common stock. That’s what people bought. That’s what investing meant to them. Mutual funds have been around for a long time, and in the last several decades, they have become today’s dominant investment vehicle.

Now a third vehicle – the exchange-traded fund – is emerging with visions of overtaking the premier role of mutual funds.

In this article we’ll look at what ETFs really are and how to figure out if they are right for you. I’ll tell you how we use ETFs for some of our managed client accounts, and why.

As we shall see, ETFs have great cost advantages for some investors. But don’t ever forget this: No matter how cheap they are, the wrong assets are still the wrong assets.

Kicking the tires

ETFs are similar in many ways to mutual funds.  Russell Wild, author of the book “ETFs for Dummies,” calls them cousins of mutual funds, and I think that’s a good description.

ETFs and mutual funds both offer access to an underlying portfolio, a pool of assets held for the common good of shareholders.

But ETFs are different from mutual funds:

• ETFs are bought and sold on stock exchanges just like individual stocks. Almost anything you can do with a listed stock, you can do with an ETF. Market prices for ETFs change constantly, just like stock prices, whenever the market is open. Mutual funds are priced only once a day, at the end of trading.

• You must pay brokerage commissions to buy and sell ETFs. It is up to you whether you use a full service or discount brokerage firm.

• There are no sales loads on ETFs, and internal expenses are typically less than those of comparable mutual funds.

• Capital gains distributions are rare with ETFs, primarily because of their design and their passive style of management.

How ETFs came to be

ETFs were invented in the early 1990s in Canada, when the Toronto Stock Exchange created the TIP (Toronto Index Participation Unit) to allow institutions to trade a basket of stocks listed on that exchange. 

The TIP was intended to generate more institutional trading (and of course more fees from trading). And institutions liked the ability to buy and sell ‘the market’ as a unit throughout the trading day.

The first U.S. ETF was the SPDR 500, whose units are based on the Standard & Poor's 500 Index and known as “spiders.” This fund’s ticker symbol is easy to remember: SPY; it remains the largest and most actively-traded ETF.

Are ETFs right for you?

Many brokers are promoting ETFs. For some people, they are an excellent answer. For many others, they are the wrong answer. Here’s my bottom-line advice:

• ETFs belong in your portfolio if you are an active short-term investor and want to speculate, hedge, short or use margin. Flexibility, low costs and relative tax efficiency have made the ETF a tool of choice for both institutional traders and individual investors who actively trade the markets. Likewise, if you are a beginning investor with little money and few options, ETFs can give you access to important asset classes without having to meet mutual funds’ minimum initial purchase requirements.

• But ETFs probably don’t belong in your portfolio if you’re using dollar-cost averaging to accumulate assets or if you’re a long-term investor who needs to re-balance your portfolio regularly. In both cases, brokerage commissions can wipe out the cost advantages of ETFs.

What could be wrong with owning ETFs?

1. You could own the wrong assets.
2. You could pay too much money in commissions or spreads.

You could own the wrong assets by not paying attention to the details of what you are buying. Many ETFs focus on familiar asset classes, but they package those asset classes in ways that are likely to result in performance different from what you would expect.

You can pay too much money in brokerage commissions when you give in to the lure of trading ETFs. An online trading commission of $10 or even less can seem minimal. But over time, those charges add up; and every dollar you pay in a commission is a dollar that will never again be working for you.

Less obviously, you can wind up paying a premium over the net asset value of the underlying assets because of the spread, or the difference at any given moment between the bid price and the ask price.

How Merriman Capital Management uses ETFs

We use ETFs for a small percent of the assets we manage for clients. Our active risk management strategy uses mechanical systems to move money out of the market when our systems indicate that there is more chance for losses than for gains – and moves that money back into the market when the chance for gains is greater.

In recent years it has become increasingly difficult to make frequent trades in mutual funds without incurring penalties and outright trading blocks. ETFs are now an excellent vehicle for making these trades quickly and penalty-free.

However, the majority of the money we manage for clients uses our globally diversified buy-and-hold strategy. We don’t use ETFs in those accounts because we cannot get exactly the right exposure to the asset classes we seek.

(To learn more about our global diversification strategy and the funds we use for it, I suggest you go to FundAdvice.com online and read two articles: “The ultimate buy-and-hold strategy” and “The best mutual funds: DFA or Vanguard?”)

What’s inside an ETF: the scoop on assets

Remember the most important thing about investing: It’s the assets! Every ETF is created by a provider that bases the portfolio on a published index that investors can look up on the provider’s web site.

However, this ease of discovery is only skin-deep. To really understand what’s “under the hood” in that portfolio you need to know how the stocks were chosen and such details as the number of holdings, average market capitalization and in the case of value-oriented indexes the strength of that value orientation.

Step one: comparing the packages

Let’s start with two easy comparisons at Vanguard, which has ETFs and mutual funds that are based on the same indexes.

In our first example, this means the portfolio of the Vanguard Small Cap Value Index Fund (VISVX) should be identical to that of the Vanguard Small Cap Value ETF (VBR).

As of December 31, 2006, VISVX had an expense ratio of 0.23 percent. Its 2006 total return was 19.2 percent. The comparable ETF (VBR) had an expense ratio of 0.12 percent. Its 2006 total return was 19.5 percent.

Second, let’s compare the Vanguard Emerging Markets Stock Index Fund (VEIEX) and the Vanguard Emerging Markets Stock ETF (VWO). At the end of December 2006, the mutual fund had an expense ratio of 0.42 percent. Its 2006 total return was 29.1 percent. The VWO had an expense ratio of 0.30 percent. Its 2006 total return was 29.4 percent.

In each case, you have a pair of investment vehicles with identical portfolios. Therefore I believe it’s safe to assume that the small differences in returns result from the packaging – and I believe the biggest difference is in the expenses charged by each package. This is very elementary: Lower expenses lead to higher returns.

However, the expense ratio isn’t the end of that equation. In each case, the slightly higher return of the ETF could easily be wiped out by brokerage commissions, depending on where you traded and the size of the trades.

Step two: opening the packages

Most comparisons are not as easy as those at Vanguard. In many cases a fund and an ETF can have similar asset-class labels but quite different portfolios.

For example, let’s compare a U.S. micro-cap ETF, the iShares Russell Microcap Index (IWC) with the Dimensional Fund Advisors U.S. Micro Cap Fund (DFSCX), a passively managed asset-class fund. At the end of December, IWC had $258 million in assets and held 1,447 stocks with an average market capitalization of $357 million. Its 2006 total return was 14.9 percent.

For comparison, at the end of last year DFSCX had assets of about $5 billion and held 2,474 stocks with an average market capitalization of $289 million. Its total return in 2006 was 16.2 percent. 

I’m guessing that the mutual fund’s higher performance resulted from the fact that last year’s market was particularly kind to the smaller companies it owns. Most of the stocks in the DFSCX portfolio have market capitalizations so small that they fall into the smallest 5 percent of all publicly traded companies.

The extra 1,000 stocks in the DFSCX portfolio make the fund more likely to achieve the returns of the asset class and less likely to suffer significantly if a few stocks turn sour.

For a second example that looks at two dimensions, compare two large international value portfolios, the iShares MSCI EAFE Value Index ETF (EFV) and the Dimensional Fund Advisors International Value Fund (DFIVX).

At the end of 2006, the ETF had an expense ratio of 0.40 percent, a price/book ratio of 2.6 and an average market capitalization of $41.2 billion. Its total return in 2006 was 30.3 percent.

The DFA fund had an expense ratio of 0.48 percent, a price/book ratio of 1.4 and an average market capitalization of $21.8 billion. Its total return in 2006 was 34.2 percent.

The first dimension is size. These are both classified as large-cap value funds. But the ETF had a portfolio with companies twice the size of the mutual fund’s portfolio. That happened to be a disadvantage in 2006 but it would in fact be an advantage during periods when larger stocks were outperforming smaller stocks.

The second dimension is the deeply discounted value of the DFA fund portfolio. Its price/book ratio in effect means the fund’s stocks were much cheaper than those in the ETF, which had a portfolio with a price/book ratio of 2.6.

When value stocks outperform growth stocks, as they have in recent years, portfolios with deeper discounts will normally do better. 

Where do ETFs come from?

Hundreds of firms offer mutual funds, but only a handful have created ETFs. By far the largest ETF provider is Barclays Global Investors, one of the premier investment banks in the world. Its ETF offerings are called iShares. The second-largest ETF provider is State Street Global Advisors (SSgA), the creator of the first U.S. ETF, the SPDR 500. SSgA is the second largest global provider of ETFs.

Vanguard, one of the largest mutual fund companies, is a growing player in the ETF market. Vanguard holds a patent that lets it offer tax-free conversions between its funds and ETFs. (Vanguard charges $50 for the conversion.)

Newer players, including PowerShares, ProShares, WisdomTree and Rydex, have built custom indexes that offer variations of the traditional indexes. These custom indexes may seem like great ideas – for instance basing value funds on dividends instead of more traditional measures like price/book ratios. However, ample research shows that value investing produces higher returns when stocks are chosen on the basis of the price/book ratio than on dividends.

In my book, these new ventures must be considered experiments. I have nothing against trying new things. But when it comes to my life savings, I have an extreme bias toward what I know and trust. That means sticking with indexes that can show me long records of historical performance.
 
What’s the best place to buy an ETF?

You’ll buy, sell and most likely hold your ETFs at a brokerage firm. Many brokerages would love to have your business. How do you choose? The two important factors are cost and convenience.

If you already own mutual funds at a brokerage house, use it for your ETFs as well.

If you hold mutual funds directly from fund companies such as T. Rowe Price, Fidelity or Vanguard, then you’ll need to open a brokerage account to buy ETFs. Choose on the basis of price. Online discount brokers will usually give you the best deals. 

You’ll want to shop for more than just commission rates. Some brokerages may charge annual or quarterly fees if your account is below a certain size. Others may charge if you don’t make a certain number of trades. You have to do the shopping and read the fine print.

You may want to start with well-known online discount brokerages such as Scottrade, TDAmeritrade, eTrade and Firstrade as well as the brokerage arms of Charles Schwab, T. Rowe Price, Fidelity and Vanguard.

Learning more about ETFs

This article is only an introduction to ETFs. Much more information is available online. You can learn a lot at Morningstar.com and at the ETF Center at Finance.Yahoo.com (finance.yahoo.com/ETF).

ETF provider sites give a vast amount of detail. Consider a visit to www.ishares.com (Barclays), www.ssgafunds.com (State Street Global Advisors) or www.vanguard.com (Vanguard). There is also more information available from the SEC, the Investment Company Institute and the stock exchanges themselves.

I also suggest “Exchange-Traded Funds for Dummies” by Russell Wild as a great introduction to the topic. Once you have mastered the basics, you’ll find a more advanced treatment of this topic in “Investing with Exchange-Traded Funds Made Easy” by Marvin Appel.

As a final note, one of the most popular features at FundAdvice.com online is our list of suggested portfolios of no-load funds and ETFs for do-it-yourself investors. There you will find two suggested portfolios that combine ETFs from several providers.