Two Good Reasons to Invest in ETFs

Despite all the buzz surrounding ETFs these days, a lot of investors are confused about how best to use them. ETFs are versatile investment vehicles, so there's more than one way to effectively incorporate them into a portfolio, and there's no one-size-fits-all approach. Here are a couple of ideas for tapping into the best that ETFs have to offer:

As a Diversified, Tax-Efficient Way to Invest a Lump Sum
When it comes to investing a large chunk of cash, you could do worse than ETFs, particularly if you plan to hold the investment in a taxable account. ETFs are essentially index funds, and they boast many of the same attractive qualities, including broad diversification, low costs, and tax efficiency.

Indeed, equity ETFs are among the most tax-efficient vehicles around. Because of the way they are structured, ETFs rarely make taxable capital gains distributions. Consequently, you'll typically owe taxes only on any capital gains that you rack up when you sell the ETF. (Dividend distributions are taxed in the same way they're taxed on traditional index mutual funds.)

ETFs are also easy to use. You can easily build a low-maintenance, broadly diversified portfolio with as few as three ETFs. For instance, you can get domestic-equity exposure in one shot through a total stock market fund, like  Vanguard Total Stock Market ETF (VTI), which charges just 0.07% in annual fees. For international diversification, there are some good one-stop foreign ETFs like SPDR MSCI All Country World ex-US (CWI) or Vanguard FTSE All World ex-US (VEU). Both funds provide low-cost access to both developed and emerging-markets stocks. To mix in some fixed-income exposure, you can turn to Vanguard Total Bond Market ETF (BND), which spans most of the investment-grade bond universe for just 0.11% in annual expenses.

So why are ETFs better suited for lump sums? 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 will be lower if you go with a no-load mutual fund.

To Invest in Undervalued Corners of the Market
There are ETFs that track practically every market segment that exists. While some of these narrowly focused ETFs are better than others, many can be used effectively if you approach them with discipline and a long-term view.

At Morningstar, we use ETFs as a way to gain exposure to undervalued areas of the stock market. Our equity analysts have placed fair value estimates on 2,000-plus stocks that they cover. By aggregating those fair value estimates, we can also estimate the fair values of hundreds of equity ETFs. To determine if an ETF is over- or undervalued, we compare our fair value estimate with its current market price. An ETF is likely to get our attention if it is trading substantially below our fair value estimate.

Keep in mind that it can take time for these sorts of calls to play out, so to benefit you must be a patient long-term investor. Taking a long-term view gives us a big edge over short-term traders and momentum players who often shy away from great fundamental investments when the short-term outlook looks challenging. In contrast, we're likely to view a short-term weakness as a buying opportunity if we think an ETF has great long-term prospects.

For more on ETFs that look cheap to us now, see my colleague Jeff Ptak's recent article, "ETFs on Our Buy List." And for our monthly analysis of ETF valuations, check out Morningstar's monthly publication, Morningstar ETFInvestor.

One Really Bad Reason to Invest in ETFs
Many investors think of ETFs as vehicles for making a quick buck on a hot corner of the market. But don't go there. Too often, by the time a hot-performing market segment catches your eye, it's just about to cool down. Unfortunately, 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.

Using ETFs as tools for short-term speculation also 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 mindset instead.

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