Image via Wikipedia
Come up with a good investment idea and it seems someone will always figure out a way to exploit it. So, here we have exchange traded funds (ETFs), which have ultra low management costs, trade like stocks and follow indexes just like mutual funds. Financial planners love ‘em for asset allocation plans, even if the average investor hasn’t quite come around. But the crooks have—just ask the guy from UBS that recently lost billions on the trading desk, trading guess what? And why is that guy smiling as they lead him in handcuffs in and out of court? I’d like a look around his apartment—closet, floorboards, mattress.
Every good investment idea lately seems to be seized and corrupted faster than normal people have a chance to understand it. Still, I think ETFs can be a great component of a sensible portfolio. Some ETFs, like those at Vanguard, are simply different share classes of the same mutual funds Vanguard has been running for years. If you stick with that type of ETF, there are several advantages for the long term (not day trader, not crazy, not nervous Nellie) investor:
- Rebalancing is much easier and more precise because you know the exact price of the shares you’re moving
- You get a much lower management cost for the same market basket as the mutual fund
- They’re more tax efficient because the manager doesn’t need to cash in shares every time somebody wants their money—the only capital gains are the ones you generate yourself, for yourself, by selling your personal shares (unless the underlying index changes, at which point the manager may do some buying and selling)
There are a few things to be careful of, however:
- Go with a company you’ve heard of. Everyone and their brother has an idea for an ETF, and some of them are too small or thinly traded to have a real market.
- Choose one based on a recognized index. The smart guys have figured out that calling something an “index” fund is a great way to deceive the Main Street investor who’s heard that index funds are a good thing. Anyone can make up a market basket and call it an index. Make sure the underlying index has some validity.
- Be very careful before buying one of the so-called active ETFs. They haven’t been around long enough to have any track record. I’m no fan of “active” investing anyway.
- Check how closely the trading price clings to the Net Asset Value (NAV). This has been a problem with bond funds, which don’t trade on an exchange like stocks. Some experts think you should stick with mutual funds for ETFs. Be aware that some ETFs can also vary from their NAV especially in specialty asset classes or highly volatile markets. During the flash crash there were some real roller coaster moments.
- If you have to pay commissions, you may be just as well off going with a mutual fund. If, however, your account offers free trades on ETFs, they deserve consideration
ETF investing has some real advantages, but like all investments your individual picture should be examined with a financial planner. You need to consider your own level of knowledge, risk tolerance, and current investments before seizing any “great idea”.
And will someone tell me why that UBS guy is smiling?
