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Tips for investing in exchange-traded funds

ETFs may leave investors confused about how to make best use of the portfolios, which come in a dizzying array of flavors.

April 05, 2013|By Tom Petruno

Exchange-traded funds have taken Wall Street by storm in the last few years.

But the boom in ETFs may leave some investors confused about how to make the best use of the portfolios, which come in a dizzying array of flavors.

Here's a practical tipsheet on investing in ETFs versus their main rivals, traditional mutual funds:

Going with ETFs is going with the market flow. The vast majority of ETFs were created to track sectors of financial markets. So using them means you are betting on specific parts of the market, and expect to earn whatever average returns those sectors generate — or suffer whatever losses they incur.

As with their cousins, "index" mutual funds, ETFs invest in market sectors that can be broad — say, the Standard & Poor's 500 index (the basis for the first ETF, the SPDR S&P 500, created 20 years ago) — or a relative sliver. The WisdomTree India Earnings ETF (ticker symbol EPI), for example, invests only in shares of some of India's largest profitable companies.

Because so many ETF options are available, and typically with low management costs, it's easy for investors to use them both as core long-term portfolio holdings and to make short-term market bets.

Investors can do the same with index mutual funds, but some mutual fund companies put limits on trading activity. ETFs, which trade on stock exchanges, have no such limits, and can be bought or sold any time in the trading day.

ETFs are the answer if you can't get a market "edge." Many professional financial advisors continue to use so-called actively managed funds, meaning those that the advisors believe can beat average market returns via adept investment-picking by their managers.

But those same advisors often turn to ETFs for market niches in which active managers may not have demonstrated much of an investing edge.

Sasan Faiz, co-chief investment officer at Morton Capital Management in Calabasas, said he turned to the Vanguard Dividend Appreciation Index ETF (symbol VIG) in 2008 because the firm believed that dividends would become more important to investors after the market crash. The ETF invests in big-name companies with a history of boosting dividends.

"It was a very efficient, very low-cost way to implement the tactical view we had," Faiz said.

Another niche Morton now favors, Faiz said, is emerging-market companies that stand to benefit from rising consumption by middle-class consumers in those countries. That sector is covered by an ETF called the EGShares Emerging Markets Consumer fund (symbol ECON).

"Tax efficiency" continues to be a key ETF lure. Because of the way they are constructed, ETFs typically don't pay out much in taxable capital gains. Rather, portfolio gains tend to build up in the share price — which means investors take them when they choose, by selling shares.

That feature can make ETFs a good choice for investors who are building a portfolio outside a tax-sheltered retirement account.

Conventional mutual funds, by contrast, by law must pay to shareholders any net realized capital gains each year, triggering a tax bill.

Years ago, the mutual fund industry hoped to get Congress to change the law to drop the forced payment of capital gains. But the idea never went very far. And with the federal government now desperate for tax revenue, a shift to delay taxes on fund gains seems highly unlikely, experts say.

ETF management fees are low, but don't forget about brokerage commissions. ETFs may make the most sense for investors who are putting a chunk of money to work at one time. That's because you'll pay a commission every time you buy or sell.

Those commissions can be cheap nowadays at online brokerages, but they can add up (although some discount brokerages have been waiving them for certain ETFs).

Mutual funds that don't charge commissions are a better option for investors who are investing small amounts on a regular basis, such as via retirement accounts. That's a big reason why ETFs haven't made much headway getting into 401(k) savings plans.

"The big players [in 401(k) plans] are saying they really don't see the demand" for ETFs in the plans, said Tom Lydon, head of ETF Trends in Newport Beach.

ETFs are also-rans in bonds, and may stay that way. Actively managed stock mutual funds have been bleeding assets since the 2008 market crash, while stock ETFs have been pulling in cash.

But in the bond market, investors continue to favor bond funds over bond ETFs.

Jim Berliner, head of Westmount Asset Management in Los Angeles, noted that a major question facing investors now is what will happen if interest rates begin to rise from their current generational lows. Any significant increase in rates would depress the value of existing bonds.

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