Be Careful of the Hidden Traps of ETFs

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Exchange-traded funds have much appeal, but look closely before you forsake traditional funds

 

Millions of investors have been racing to buy exchange-traded funds (ETFs). Like index mutual funds, ETFs track benchmarks, such as the Standard & Poor's 500-stock index. But ETFs trade constantly on stock exchanges, while mutual funds are priced once a day.

 

For many investors, ETFs can be a good value, but the funds also come with traps. In many cases, investors should avoid certain ETFs in favor of conventional mutual funds. With more than 500 ETFs now available, fund companies have been introducing increasingly specialized choices. Now you can buy selections that focus on oil, Swedish stocks, or medical devices. But the specialized niches can be extremely volatile; when the Swedish market nose-dives so will your investment. Most in-vestors would be better served with a diversified mutual fund that may provide steadier results. “You should not buy the narrow choices unless you are a very sophisticated investor with a clear strategy,” says Tom Lydon, a financial advisor in Newport Beach, California.

 

Part of what draws investors to ETFs is their claim to involve tiny expenses, and the best funds do deliver on that promise. Many charge minimal expense ratios, dipping as low as 0.09% annually. But some choices hardly qualify as bargains. Claymore MACROshares Oil imposes an annual expense ratio of 1.60%, well above the figure for the average domestic equity mutual fund. Prime Shares DB Agriculture charges 0.91%. Investors who want to save on costs should stick with funds like Vanguard Small Cap ETF, which has an expense ratio of 0.10%. “There is not much point in owning an ETF that does not come with low costs,” says Jim Wiandt, editor of Index-Universe.com.

 

While ETFs charge all customers the same annual expense ratio, many conventional funds give discounts for big investors. The SPDR S&P 500 ETF charges all customers 0.10%. That may look better than the Vanguard 500 index mutual fund, which charges a base rate of 0.18%. But if you put $100,000 into the Vanguard fund, the expense ratio drops to 0.09%, and there are no brokerage commissions. When all the trading costs and expenses are totaled, investors who want to put less than $5,000 into the S&P 500 should use a mutual fund. Those who put in more than $100,000 should also stick with mutual funds. Only those who are investing one lump sum that is between $5,000 and $99,000 may do better with the ETF.

 

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