by Archie M. Richards, Jr., CFP^®
June 9, 2003

Ken wrote, "Concerning exchange-traded funds, I believe you wrote that being able to buy and sell them during the trading day makes them preferable to mutual funds. For investors with a long term perspective, trading doesn't seem appropriate. What are the advantages of ETFs?"

Ken, you cite what most investment professional think, not me. I believe that trading usually doesn't pay off. The trades are often mistimed. The buying and selling also increases commissions and other transaction costs. Being tempted to trade ETFs is a disadvantage.

But otherwise, exchange-traded funds (ETFs) are terrific. They're similar to mutual funds, only better, as follows:

• ETFs have lower operating costs. Actively-managed mutual funds perform research in an effort to pick stocks that will outperform others. They also trade frequently, trying to catch price swings. But exchange-traded funds don't need research; they simply buy and hold the stocks that are included in the index. Since the stocks in indexes are changed infrequently, ETFs trade their holdings infrequently. ETFs even have lower operating costs than index mutual funds.

• ETFs are less likely to throw off capital gains. You may have bought a mutual fund whose value fell. But despite the decline, you nevertheless had to pay capital gains. With ETFs, this is unlikely.

• ETFs hold no cash, All the money selected for an index goes to work in the stocks included in the index.

• ETFs don't reinvest dividends. Those are paid to your brokerage account. Assuming they aren't needed for spending, some people consider this a disadvantage, because getting the money back to work causes a delay. But receiving dividends outright does have an advantage: You can use them for rebalancing. It's a good idea to hold many exchange-traded funds, each representing a different class of investment. I recommend 30 percent in U.S. stocks of different characteristics, 30 percent in foreign stocks of different regions, 20 percent in real estate investment trusts, and 20 percent in long-term bonds. Over time, some groups perform well and others poorly. Use the dividends to add to the funds that have performed poorly.

• Over 200 ETFs are available, offering a huge variety of index choices.

• All the exchange-traded funds you hold appear on one brokerage statement. Computing the relative values of the ETFs is a cinch. But if you hold mutual funds managed by different companies, transferring money from one company to another is a pain.

• ETFs are certainly preferable to individual stocks. Fluctuations of the entire market involve considerable risk. But if you stay in for the long term, you're well paid for that risk. Buying individual stocks, however, adds additional risk for which you are not rewarded. The market may rise, but your particular stocks may go down. For most investors, the individual stocks they hold perform worse than the market as a whole. But most exchange-traded funds own all of the stocks that are included in a market index. As the index goes, so goes the ETF.

It's okay to hold individual stocks, for the fun of it and the challenge. But keep those investments down to 10-25 percent of your total portfolio, preferably on the low side. Never mind trading them, either; hold each one for at least five years.

Despite the advantages of exchange-traded funds, they're not for everyone. If your company's 401(k) plan is the only investment you have, and it doesn't offer ETFs, they're out of the question for you.

ETFs are also inappropriate if you regularly contribute small amounts to your portfolio. The commissions would be too high. Say you're investing $500 a month, adding the money to only two ETFs. Assume the commissions for your on-line brokerage firm, such as Ameritrade, are $11 each. The cost would be $22. That's 4.4 percent of $500, which is excessive. Better to use commission-free index mutual funds, like those of Vanguard.

But let's say you have already accumulated at least $40,000, for example. You want to buy eight ETFs. With commissions of $11, the total is $88. This is only 2/10ths of 1 percent of $40,000, which is insignificant.

Exchange-traded funds shouldn't be traded. But for portfolios of even moderate size, they're fine investment vehicles.