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Tuesday, 24 November 2009

5 Myths About ETFs


Investing in ETFs may not be simple as what you think and you still need to spend fair amount of time and energy to pick the right ETFs that are suitable for your investing goals and horizon; otherwise, it is probably just "blind" investing and hoping for the best.
by Michael Iachini

Key points

  • Here are five commonly held myths of ETF investing and why it pays to look beyond your first assumptions.
  • Consider carefully what it is you're looking for from an ETF before you buy—and make sure your ETF delivers what you need.
  • Find out whether ETF investing is right for your portfolio needs.
you probably know a thing or two about exchange-traded funds, better known as ETFs. You know that ETFs are basically index mutual funds that trade like stocks. You know that they have low expenses and are easy to trade. You know that they are a cheap, easy, tax-efficient way to get good diversification.

Or you think you know all of that.

In fact, many ETFs may not have all of the good characteristics that you associate with this increasingly popular investment type:

Many ETFs have higher expenses than you might expect.

Some ETFs can be difficult and expensive to trade.

Rather than traditional indexing, some ETFs flirt very openly with active management.

Some ETFs can give you taxable income.

Certain ETFs give you no diversification at all.

Here are five commonly held myths of ETF investing and why it pays to look beyond your first assumptions.

Myth No. 1: All ETFs have low expenses

The first thing that many investors think about when they consider the good qualities of ETFs is the low expenses they carry. This is true for many traditional ETFs, such as the S&P 500 SPDR (SPY), which tracks the S&P 500® index and carries a tiny expense ratio of 0.09%.

But did you know that some ETFs charge much more? For instance, most ETFs that track single-country indexes—such as the iShares for the United Kingdom (EWU), Australia (EWA) and Germany (EWG)—charge 0.52%.

You'll also tend to pay more for funds that are focused on a specific industry, such as the iShares Dow Jones U.S. Oil and Gas ETF (IEO), which charges 0.48%.

Another example: ETFs that follow unconventional indexes, such as WisdomTree DEFA High-Yielding Equity ETF (DTH), which charges 0.58% and weights stocks according to fundamentals like earnings, dividends and cash flow.

ETF expenses currently top out at 1.53% with Claymore/Ocean Tomo Growth (OTR), an ETF that aims to invest in companies that own valuable patents.

The expenses might be worthwhile if you need the specific exposure the ETFs provide, and they are still generally less expensive than many actively managed mutual funds. But be aware: The fact that something is an ETF doesn't necessarily mean it's the cheapest option.

If you're trying to compare expenses between an ETF and a mutual fund, the expense ratio is a good place to start.

Myth No. 2: All ETFs are easy and cheap to trade

Investors also love ETFs because of their liquidity—the ease with which they can be bought and sold. It's true that you can trade ETFs anytime during the day, just like a stock.

But there's a cost to trading, and it's not just commissions. Whenever you buy or sell anything on an exchange, there's a bid-ask spread—the difference between the higher price at which investors are asking to sell and the lower price at which they're offering to buy.

For ETFs that are actively traded all day long, the bid-ask spread tends to be quite small. But less-liquid ETFs (that is, those that are harder to trade) tend to have much larger spreads.

In addition, unlike open-end mutual funds, the price of an ETF doesn't necessarily match the net asset value (NAV) of the securities in its portfolio. The difference is known as the discount or premium to NAV, and it can be very unpredictable.

More-liquid ETFs tend to have smaller discounts and premiums. So while you can trade an illiquid ETF anytime, it might cost more in spreads.

For example, one lesser-known ETF, Claymore/Zacks Country Rotation ETF (CRO)—which tracks an index of international stocks that changes its country focus over time— had an average daily trading volume for the month of July 2009 of only $15,000 per day, with no volume at all on eight of the 22 trading days in the month.

During the same period, the widely traded S&P 500 SPDR (SPY) had an average daily volume of more than $18 billion—over one million times that of the lesser-known fund.

According to data from XTF, the average bid-ask spread for the less-liquid CRO fund during this period was 1.66% of the price of the fund. During the same period, the average bid-ask spread for the ultra-liquid SPY fund was only 0.01%.

If you had accepted the price the market had set each time you traded, it could have cost you 1.66% of your investment to trade CRO but only 0.01% to trade SPY.

Myth No. 3: All ETFs are index funds

You may like ETFs because they're index funds. With an index fund, you get all of the stocks in the index without having to worry about whether the portfolio manager is picking the right securities or not—the manager just buys them all.

However, not all indexes tracked by ETFs are traditional market indexes like the S&P 500.

Some indexes, like the PowerShares Intellidex indexes, are effectively actively managed; the company that puts the index together tries to include only stocks that it believes will outperform the market. And a few truly actively managed ETFs have been launched recently, such as Grail American Beacon Large Cap Value ETF (GVT).

This leaves you open to the possibility that the people or companies assembling the index will be wrong about which stocks will outperform. That's called active management risk, and avoiding that risk is one of the features of indexing that some ETFs fail to provide.

For example, the PowerShares Dynamic Market ETF (PWC), which is a total-market fund (meaning it includes very small to very large companies), has outperformed the total-market Russell 3000® index (which follows the 3,000 largest public US companies) by as much as 2.9% in a single month since its June 2003 launch—but it has also underperformed that index by as much as 4.2% in a single month.

Contrast this with a traditional total-market index ETF, the iShares Russell 3000 Index (IWV), whose returns have been within 0.05% of the index every month in that time period. While the more active fund may outperform a traditional index, the risk of underperforming is present, as well.

One way to tell if you're getting an actively managed fund in disguise is to read the language in the ETF's prospectus describing the index the fund is following. If the index picks stocks that are "expected to outperform," investigate further.

Myth No. 4: All ETFs are tax-efficient

Much has been made of the tax-efficient nature of ETFs, and it's true that they are often more tax-efficient than similar mutual funds.

Myth No. 5: All ETFs give you diversification

Finally, you may like the easy diversification provided by an ETF—by making one trade, you suddenly have a well-diversified domestic equity portfolio. This is certainly true for many ETFs. For instance, by buying one share of the iShares Russell 3000 Index (IWV), you gain exposure to nearly all stocks in the US markets.

This isn't true of all ETFs, though. Very narrow ETFs may provide you with very little diversification. iShares Dow Jones US Energy (IYE) looks diversified with 76 holdings, until you realize that more than half of its assets are concentrated in just five stocks! Buying shares of a gold (IAU, GLD) or silver (SLV) ETF gives you access to exactly one asset.

Generally speaking, the more narrowly defined the index, the less diversification it gives you. You can find the percentage of a fund concentrated in its top 10 holdings in the ETF Visual Screener on

Myths debunked

Now you understand that not all ETFs are alike. Although many ETFs are good tools for providing inexpensive, highly liquid, tax-efficient diversification without taking on active management risk, some ETFs fail to live up to this billing.

Consider carefully what it is you're looking for from an ETF before you buy—and make sure your ETF delivers what you need

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