Exchange-Traded Fund Myths Busted

It seems like I can't open a newspaper these days without reading about how popular exchange-traded funds are or how much better they are than regular mutual funds. Some of this is true, but some of it is just hype. Because one of the easiest ways to lose money is to misunderstand your investments, I'll use this month's ETF Spy to dispel some popular misconceptions about these vehicles. Here's the straight dope on a few ETF myths.

ETFs are getting all the fund flows.
They're getting a lot, but not all. Altogether, ETFs had about $251.5 billion in assets at the end of August 2005 compared with traditional mutual funds' $8.5 trillion, according to the Investment Company Institute. ETFs also netted about $18 billion in new money in 2005 through the end of August, the ICI says. That's about 11% of all new money in any kind of fund, exchanged traded or otherwise. So, yes: You can say ETFs are hot sellers, but they're certainly not gobbling up everything.

ETFs must perform better than mutual funds.
There is nothing about ETFs that guarantees they'll perform better than traditional mutual funds. Currently, just about all ETFs are index funds. Like their conventional index fund counterparts, they try to mimic the returns of their benchmark indexes. When the indexes do well, so should the ETFs that track them. When the benchmarks do poorly, so will their corresponding ETFs. Low costs and diversification give ETFs a very good shot at beating the average comparable actively managed fund over the long term, but you could say the same for many regular, no-load index mutual funds.

ETFs are always the cheapest option.
This is often true, but not always. It's possible to find traditional mutual funds with expense ratios as low or lower than those of ETFs and that can be bought without the commission or bid-ask spread that you must pay to trade ETFs.

There are nearly 60 traditional no-load mutual funds (excluding funds of funds and municipal bond offerings) in Morningstar's database that are still open to new investors and have expense ratios as low or lower than the median ETF levy of 0.30%. Most of them are (not surprisingly) from Vanguard and include offerings that also can compete with the vaunted tax efficiency of ETFs, such as Vanguard's series of quantitatively run tax-managed funds. There are some worthy offerings from other shops, too, such as  Fidelity Spartan 500 ,  Fidelity Spartan U.S. Equity ,  Fidelity Spartan International , and  Bridgeway Blue-Chip 35 Index . Once you factor in the brokerage commissions you have to pay to trade ETFs, these funds are often as cheap or cheaper than ETFs.

Online brokerage fees have dropped, so it's safe to dollar-cost average into ETFs.
Yes, online brokerage fees have fallen. Nevertheless, given roughly equal expense ratios, most long-term investors are still better off with the traditional open-end index fund. For example, assuming an online brokerage commission of $12 (the current average according to Consumer Reports) and a return of 7%, someone who makes an initial investment of $10,000 in Fidelity Spartan 500 and subsequent monthly contributions of $250 would have $1,900 more in his or her account at the end of 10 years thanks to cost savings and compounding than if he or she followed the same plan with  iShares S&P 500 (IVV).

ETFs' structure always makes them more tax-efficient choice.
They should be and often have been more tax efficient. Being low turnover index funds helps. More importantly, though, ETFs can avoid capital gains because unlike traditional funds, ETFs can pay off redeeming shareholders with baskets of their underlying portfolios' stocks instead of cash. Savvy ETF managers also can use that in-kind redemption process to get rid of the stock shares with the biggest unrealized gains.

The system seems to work. No iShares ETFs have issued capital gains in four years and distributions have been rare at other shops, too. Yet it pays to examine this claim closely. For instance, the  Vanguard 500's (VFINX) tax cost ratios for the trailing one-, three-, and five-year periods ending in September are lower than those of both of its ETF competitors:  SPDR (SPY) and iShares S&P 500 Index. That means Vanguard shareholders lost less of their returns to taxes than investors in the ETFs. Indeed, the Vanguard 500's actual after tax returns (assuming an investor doesn't sell the fund at the end of the time period) also are better than its exchanged-traded rivals. This shows traditional fund managers who pay attention taxes can be more than competitive with ETFs.

ETFs can be a smart way to invest, but they're only as smart as the people who use them. In the right hands ETFs can be affordable and convenient ways to get broad exposure to the market or particular asset classes, as well as to manage risk. To the imprudent or uninformed, though, ETFs offer new opportunities to sap returns by racking up transaction costs and/or chasing short-term trends.

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Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.