By Michael Rawson, CFA
Over the past few years, exchange-traded funds have made a big impact on the 80-year-old mutual fund industry. But do these new products belong in conservative portfolios?
Some regulators and investors have warned about hidden risks in ETFs and the dangers of exotic investment options. While many of their concerns are valid, we think tarring the whole industry is throwing the baby out with the bath water. Not all ETFs have the same operational and investment risks. In fact, many ETFs are perfectly suitable for a retiree's portfolio. They're easy to spot, once you know what traits to look for: simplicity, low costs, and diversification. Here we provide quick tips on how to navigate through the muddied waters.
Keep It Simple
Not all investors need ETFs. Sure, they may be tax efficient and cheap, but so are many index mutual funds. Sometimes ETFs may not justify their added complexity. You can save a few bucks changing the motor oil yourself, but I wouldn't recommend it to everyone. ETFs are at least somewhat hands-on. They are bought and sold like stocks, and also have similar liquidity considerations. Trading a less-active ETF, say one with less than $100 million in assets, requires a bit more caution than buying a mutual fund. You might end up buying at a premium or selling at a discount.
Fortunately, the cheapest, most efficient ETFs tend to be liquid. Stick to big ETFs for an added measure of safety. And always use limit orders to buy ETFs near net asset value. You can get a real-time quote on the NAV by appending ".IV" to an ETF's ticker symbol when you search for it. Even rare events like the flash crash, which briefly resulted in many ETFs trading at steep discounts, could've been avoided by judicious use of limit orders.
A key consideration is that ETFs incur trading costs. If you're paying $7 a trade and are trading only a few hundred dollars at a time, a mutual fund is probably better. ETFs are best when dealing with large quantities of capital or at least with low-cost or free trading. Smaller investors should look to Vanguard, Schwab, Fidelity, or TD Ameritrade for free trading with a selection of ETFs.
It may also be prudent to avoid ETFs if you know you have bad investing habits that could be exacerbated by the liquidity and variety of ETFs. Bad habits might include trading too frequently and attempting to play macroeconomic themes through wholesale shifts of your asset allocation, regardless of tax and cost considerations. When he found out that ETFs would allow trading in the S&P 500 all the time at any time, Jack Bogle pointedly asked, "What lunatic would want to do that?" Bogle rightly brought the focus back to investor behavior. The vehicle itself does not matter as much as the process of investing. Avoiding behavioral mistakes can save you a lot more than the relatively minor savings you can gain with ETFs.
Another thing for people who trade their own portfolio to consider is estate planning. If you hold a large number of ETFs that need to be manually rebalanced, will your children remember to do this? Will you be able to monitor your statements should you have a medical emergency and you are away from your computer for several weeks? This again argues for a simple approach of using allocation or target-risk funds.
Good ETF, Bad ETF
A retiree will likely only need to use ETFs for asset allocation. Such ETFs track broad, diversified indexes the MSCI U.S. Broad Market Index or the Barclays Aggregate Bond Index. Vanguard Total Stock Market ETF (NYSEARCA:VTI) or iShares Barclays Aggregate Bond (NYSEARCA:AGG) are great choices. They're simple, transparent, cheap, and liquid. While most ETFs are index funds, not all indexes are good. Some are essentially computer-run active strategies or alternative weightings that may or may not make sense. A good way to make sense of whether an ETF is good is to do due diligence by reading Morningstar's ETF reports.
The broad diversification of ETFs means that a complete portfolio can be built with just a few securities. My colleague Christine Benz has written extensively on conservative and even aggressive ETF portfolios for retirees.
If you have specific needs and are looking to venture off the beaten path, look at exotic funds, like leveraged or structured products, or investments that you'd never heard of five years ago. For example, unless you are an active trader, there is no need for the typical retiree to invest in sector-specific funds such as Technology Select Sector SPDR (NYSEARCA:XLK). Likewise, investors will have no use for expensive, complex, structured products such as iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). Despite their names, many leveraged funds do not promise returns beyond a single trading session.
In summary, retirees and cautious investors can benefit from certain ETFs but there is no obligation to go outside your comfort zone. Keep in mind that not all ETFs are user friendly and all ETFs require at least some basic trading knowledge. When planning your estate, it's best to simplify your portfolio to avoid creating a future burden.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.