ETFs are lower cost and more tax efficient than mutual funds. That is a given. You shouldn’t invest in something because it’s inexpensive, though. Beyond costs, a crucial element of any investment strategy should be the management of (1) asset concentration risk and (2) strategy discipline. ETFs are ideal for both, and here’s why.
Transparency … If ignorance is not bliss then holdings transparency is a big deal. Have you ever attempted to find out what your mutual fund currently holds? You can’t. Why? Because mutual funds are required to report holdings only once per quarter and, at that, one quarter in arrears. That means that any mutual fund holdings report that you would have represents the fund’s holdings at from least three and as much as six months ago. ETFs are required to report holdings on a daily basis. You always know what you’re holding in an ETF.
Active mutual fund prospectuses generally grant managers license to roam widely on the securities landscape in pursuit of return, and that they generally do. Accordingly, it’s not uncommon, especially during turbulent times, for portfolio holdings to vary significantly from month-to-month or quarter to quarter. And, yet, as shareholder of actively managed mutual funds, you’ll never know with certainty what you hold at any given time.
Breadth and depth of coverage, precision and purity of exposure – ETFs do it as well or better across the board, in every asset class. ETFs cover U.S. and non-U.S. equities of all capitalizations, style and sector/industry flavors as well as emerging markets. On the ETF menu are government, TIPS, municipal, agency, corporate investment grade and high yield, and international fixed income offerings. In the “alternatives” arena there are commodities, currencies and REITs.
Precision and purity in exposure … ETF holdings are designed to replicate or approximate the holdings of an index. Holdings within indexes, such as the S&P 500, are established according to a set of rules specific to a given index. Understand the mechanics of the index and you understand not just what your ETF holds but how it arrives at those holdings and you also know, unlike with actively-managed mutual funds, that it’ll have the same sort of holdings in the future.
Favorable performance histories relative to active fund managers … Find an active fund manager who has managed to beat his generic index benchmark in a given year and, behold, you’ll have a manager residing squarely in the minority. Well under one-half of active mutual fund managers beat their generic index benchmark in a given year; less than ten percent pull it off three years in a row. Investors have increasingly learned that they’ve got far better off buying the active fund manager’s benchmark index, which can be done through an exchange traded fund, than by placing their bets with the active mutual fund manager.