Gimme that old-time religion. . . . These new hip-and-happening exchange-traded funds aren't good enough for me.
Back in the old days - say, two or three years ago - ETFs were just a super-low-fee alternative to the venerable index-style mutual fund. In some cases, an ETF would be a better choice because it provided bigger tax savings.
And in some cases, an ETF was the only choice. If you wanted to invest in the 30 stocks of the Dow Jones industrial average, there was an ETF known as Dow Diamonds, while there was no comparable mutual fund.
Now, there are nearly 350 ETFs, about 40 percent of them created in just the last year. Many new ones track super-narrow slices of the stock, commodities or currency markets that are very risky. And last week, some news reports said the Securities and Exchange Commission might soon approve the creation of actively managed ETFs – with managers' hunting for hot stocks instead of just duplicating a market gauge like the Dow.
ETFs started out simple. Like an index mutual fund, a classic ETF owns a basket of stocks mirroring those in a standard market index such as the Dow or Standard and Poor's 500. If the index goes up 5 percent, ETFs based on it should go up 5 percent.
The difference: An ETF is traded like a stock, through a broker.
This is why ETFs are so tax efficient. When an investor contacts a mutual-fund company to redeem fund shares, the company sells stocks to raise the cash. Profit on those sales may be paid out to shareholders in a taxable year-end distribution.
In an ETF sale, you just sell to another investor, as you would with a stock. The ETF issuer doesn't have to unload stocks to generate cash, so there are no taxable distributions.
Because the ETF issuer doesn't have the expenses of handling purchases and redemptions, fees are very low. The Vanguard 500, the granddaddy of index mutual funds tracking the S&P 500, charges annual fees equal to 0.18 percent of the amount invested, which is pretty low. But the Spider ETF using the same index charges 0.08 percent - about half as much. (The typical managed stock fund charges upward of 1.3 percent.)
So far, so good. What's the downside?
It's this: Many of the newest ETFs track very narrow slices of the market, such as stocks in a given industry or country. With these, investors are concentrating risk rather than spreading it among the dozens or hundreds of stocks owned in a classic ETF or index mutual fund.
Also, the narrow ETFs tend to have higher fees, negating one of the chief benefits of index-style investing. Last year, the securities-data company Morningstar Inc. found that narrowly focused "sector ETFs" had average annual fees of 0.45 percent.
And many of the indexes tracked by the narrow ETFs change their member stocks relatively often. That forces the issuer to sell the stocks that are dumped. And that can trigger taxable distributions.
Even the classic, broad-based ETF is not always for everyone.
One problem is the broker's commission you must pay when you buy or sell an ETF. There is no commission when you buy or sell no-load mutual funds by dealing directly with the fund company.
ETFs are thus not good for investors who want to make regular, small purchases, because commissions can offset the low fees. These investors should use no-load mutual funds and deal directly with the fund company without a broker.
ETFs can be a good choice for people making large lump-sum investments, because a single commission is small compared with the fee savings. But remember: Even if you make a lump-sum purchase, commissions could pile up if you make numerous small withdrawals to fund your retirement.
Don't get me wrong - I'm not against ETFs. The traditional ones tracking the S&P 500, Dow and other big U.S. and foreign indexes can be great for long-term investors. Hunt them down at www.morningstar.com.