ETF Solutions, Morningstar

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ETF Solutions

Are ETFs Right for You?

Slide 2: Are ETFs Right for You?

ETFs appeal to different types of do-it-yourself investors. Some day-traders like ETFs because of their stock-like qualities and because they can find ETFs that focus on individual sectors or markets. And investors who prefer index funds over actively managed offerings find ETFs appealing because many of them are very cheap. In this ETF Solution, we'll take a closer look at ETFs, their advantages, and disadvantages.

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Slide 3: Are ETFs Right for You?

ETFs should have appeal for cost-conscious investors who don't trade frequently. Multiple studies by Morningstar have shown that a fund's expense ratio is a reliable predictor of future success. And because ETFs trade on an exchange, transactions occur directly between investors, meaning ETF providers don't have to manage hundreds of customer accounts or staff call centers--lowering overhead and, by extension, expense ratios. On average, ETFs have a noticeable expense ratio advantage over the typical passive and actively managed mutual funds in many of Morningstar's fund categories.

Slide 4: Are ETFs Right for You?

While ETFs' low expenses are touted as one of their key benefits, the fact remains that if, like most people, you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many mutual funds.

You pay a brokerage commission each time you buy and sell an ETF, so your costs mount with each trade. Commissions can add up quickly, so if you plan to make periodic investments over time, your overall costs could be lower with a no-load mutual fund.

Morningstar's Cost Analyzer is a handy way to compare hypothetical investments and determine which investment is right for you.

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Slide 5: Are ETFs Right for You?

ETFs may hold a special attraction for investors in taxable accounts. With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions.

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Slide 6: Are ETFs Right for You?

Furthermore, redemptions made by large investors are paid in kind, again protecting shareholders from taxable events. All of this should make ETFs more tax-efficient than most mutual funds. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.

Click here to view the accompanying video.

Slide 7: Are ETFs Right for You?

On the cost front, an ETF will often be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For all others, an exchange-traded fund isn't likely to have a big cost advantage over a plain-vanilla, low-cost index fund.

Slide 8: Are ETFs Right for You?

The ETF universe is flush with options that focus on a single market sector, industry, or geographic region. This means that exchange-traded funds can offer a way to invest in a corner of the market without having to load up on just one or two individual stocks. If you're inclined to invest in more-focused ETFs, it makes sense to be a contrarian, not to chase what's been hot recently. Too often, by the time a hot-performing market segment catches your eye, it's just about to cool down. Unfortunately, some ETF providers have a bad record of launching new ETFs in faddish corners of the market, a practice that tends to encourage investors' worst instincts.

Slide 9: Are ETFs Right for You?

Using ETFs as tools for short-term speculation negates two of their best features: low costs and tax efficiency. If you trade frequently, brokerage commissions can add up fast, thereby eroding the ETF's low-cost advantage. Quick trades also trigger tax consequences, which can be particularly onerous if you hold an ETF for less than a year and incur the higher short-term capital gains rate. So to benefit from ETFs' best features, avoid the quick-trading crowd and adopt a disciplined, long-term mind set instead.