The ascent of exchange-traded funds has many investors wondering whether to abandon mutual funds and join the stampede into ETFs.
It's not hard to understand why. ETFs didn't gain popularity until the turn of the millennium, but they have been on a tear in recent years. There are now more than 1,600 U.S.-listed ETFs with some $2 trillion in assets under management, although that's still a fraction of the $13 trillion in open-end mutual funds, according to Morningstar.
Last year ETFs had their strongest yearly inflows ever, more than $241 billion, and asset managers rolled about 200 new funds.
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Most ETFs are passively managed, meaning they track a stock or bond index, and that helps to keep their costs low compared to actively managed mutual funds. For many advisors, ETFs are an easy, low-cost way to provide clients with exposure to certain market segments when putting together a diversified investment portfolio.
Anyone with a brokerage account can buy shares in an ETF, which is a pool of securities that trades on a stock exchange. ETF prices are updated throughout the day, while mutual funds are priced once a day after the markets close.
"You have a growing adoption of passive investment strategies, and that has helped ETFs gain popularity," said Alex Bryan, an analyst at Morningstar. "After the financial crisis, a lot of people were disillusioned with the poor performance of actively managed funds."
Yet even advisors who have embraced ETFs say investors shouldn't be too quick to buy into the notion that mutual funds are passé. Some advisors say the proliferation of ETFs has led to confusion among consumers and that many individual investors don't fully appreciate the risks associated with some of the exotic ETFs that have hit the market in recent years.
"Pushing the overall cost of investing down is a good thing, as ETFs have done, but I also believe the competitive marketing environment has contributed to the proliferation of ETFs," said Tim Maurer, a certified financial planner and director of personal finance at Buckingham and The BAM Alliance. "There is this notion that if a little bit is good, then a whole lot is better."
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He added, "That's essentially where we are right now."
Many investors believe ETFs are cheaper than comparable mutual funds, but that's not always the case, said Artie Green, a CFP and a principal at Cognizant Wealth Advisors. "There are numerous examples of mutual funds in certain asset classes that are less expensive than their ETF counterparts," wrote Green in a blog posting.
A recent Morningstar study comparing the average expense ratios of index-based ETFs and comparable mutual funds found that ETFs were only cheaper than their mutual fund counterparts in a few categories, on an asset-weighted basis.
Asset weighting gives larger funds greater influence on an average, mitigating the influence of small funds, which tend to have higher expense ratios. For that reason, an asset-weighted average is a better representation of the average investor's experience than a simple average, according to Morningstar's Bryan.
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The Vanguard Group's dominance in the mutual fund arena had a big influence on the study's key finding when it comes to comparative asset-weighted expenses, Bryan noted.
"Vanguard prices all their funds at cost, so their large presence in the mutual fund space pulled down average asset-weighted expenses," he said.
While expenses are important, they certainly aren't the only factor to consider when deciding between an ETF and comparable mutual fund, experts say. The tax efficiency of ETFs, which is tied to the way they handle redemptions, gives them a big advantage over mutual funds for those investing through a taxable account, Bryan said.
On the other hand, investors building a portfolio through small, regular contributions might be better off using mutual funds, many of which can be bought on a no-load, or commission-free, basis directly from fund companies. ETFs are typically sold through a brokerage, and in most cases investors must pay commissions to buy shares.
While many of the first ETFs simply tracked the major indexes, investors can now choose from a mind-boggling array of products. Advisors say it behooves investors to look under the hood, as they should do with any type of investment product.
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"There are four to five indexes that cover the large-cap space, and they are all a little different," said Green at Cognizant Wealth Advisors. "Depending on the index and trading strategy, you can have a difference in returns among comparable ETFs."
So-called strategic beta funds are one of the fastest-growing categories of ETFs. The number of strategic beta funds—which are also called smart beta, alternative beta and enhanced index funds, among other monikers—has nearly doubled over the past four years to some 400, according to Morningstar. The funds had more than $402 billion in assets under management at the end of last year.
Strategic beta funds deviate from the strategy of simply tracking market-cap weighted indexes. The funds track tailored benchmarks in an effort to boost returns or manage risk.
For instance, Vanguard's Dividend Appreciation ETF tracks the Nasdaq U.S. Dividend Achievers Select Index, which is derived from the Nasdaq U.S. Broad Dividend Achievers Index and includes stocks that have a history of increasing their dividends in each of the last 10 years.
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In theory, strategic beta funds should be less expensive than similar actively managed funds because they track indexes, said Morningstar's Bryan.
In addition to considering cost, investors ought to focus on funds that provide actual performance information, not back-tested results, and detailed information about the construction of the indexes they track, he said.
Although ETFs have gained a strong following among advisors, some of the funds have raised a few eyebrows. Green, at Cognizant Wealth Advisors, said he avoids leveraged ETFs "like the plague." The funds use derivatives to amplify the returns of an underlying index.
According to Green, they generally perform as expected if the indexes they track consistently rise or fall in value over time. But during times of volatility, their structure tends to exaggerate losses more than gains, which can produce nasty surprises for investors who don't fully know what they are getting into, he said.
"The only people these would really appeal to are day traders, and as far as I am concerned, they are gamblers trying to predict short-term movements of individual stocks or asset classes," Green said.