ETF Advantages Becoming More Apparent to Some

It's hard to believe that more than two decades have passed since the first exchange-traded fund,  SPDR S&P 500 ETF (SPY), made its debut. Yet, in some ways, ETFs still feel like the new kid on the investing block, especially for investors who have long stuck with individual stocks and bonds or mutual funds.

But ETFs are increasingly becoming part of the mainstream, their growing popularity driven in part by the fact that ETF fees tend to be lower than those charged by traditional mutual funds but also due to an increasing appetite for index-based products (the vast majority of ETFs are index-trackers). ETFs also offer fund investors the ability to trade while markets are open, something traditional open-end mutual funds can't offer.

Last week, the Morningstar ETF Conference was held in Chicago, the latest version of an annual event begun in 2010. This year, the conference had to be moved to a new hotel to accommodate growing interest in an investment vehicle that now accounts for about $1.9 trillion in assets held across more than 1,400 ETFs.

To mark the occasion, we asked Morningstar readers on our Exchange-Traded Funds discussion board if they are using ETFs more now than in the past and how they are using them. Many wrote enthusiastically about why they prefer ETFs to traditional mutual funds, although not all were completely sold. Excerpts are below, and you can read the full discussion here.

'What's Not to Like?'
One common theme among readers was the fact that ETFs provide exposure to parts of the market that are not accessible in other ways.

AllenG wrote, "I personally use ETFs to gain access to market areas that are more expensive and/or less available via traditional mutual funds. Emerging-markets small caps, international small-cap value, and frontier markets come to mind first."

"I use ETFs for shorter term trades, mostly in sectors (gold/silver, energy, tech, oil, etc.) and some specialty areas (commodities, regions/countries, etc.)," wrote yogibearbull. "For longer-term core positions, I use mutual funds, which make reinvestments easy."

"I dollar-cost average into open-end funds for my core [portfolio] and use ETFs for shorter-term timing plays or specific sector coverage," said dndhatcher.

Bobboy summed up his preference for ETFs this way: "They are less expensive, trade like stocks so you don't have to wait until 5 o'clock [to find out their value], no capital gains [distributions]. What's not to like? Full control, great diversification at one third the price."

Retiredgary's remarks also focused on price, but mentioned another advantage ETFs have over traditional mutual funds: no investment minimums.

"We are using them more for various reasons," he said. "The first is the low expenses and often zero commission they offer. We have found them convenient ways to make investments in specific countries or sectors. The lack of minimum purchase requirements and the ability to know the exact price at the time of the transaction give them advantages over ordinary mutual funds in some situations."

Km0010 agreed that low minimums give ETFs a leg up on traditional mutual funds. "I won't want to make such a large $10,000 bet on a Vanguard admiral class sector index," the poster wrote. "But, with their ETF version of the index, it's the same low cost practically without the minimum purchase. (You don't even need $1,000 for a beginner to start investing.) And, you can find plenty of commission-free ETF brokerages these days. All of this makes sector index funds obsolete."

For dtobisk, ETFs make a perfect gift. "For his 14th birthday a few months ago, I gave my son $1,500 to invest at Vanguard--the object being to get him interested and excited about the potential for growing money instead of immediately spending it," dtobisk wrote. "He was able to buy a few shares of two different ETFs ( Vanguard Small-Cap ETF (VB) and  Vanguard Information Technology ETF (VGT)) with this modest amount of money because there's no minimum purchase amount and no commission cost. I can't say the experiment has been successful yet, but one can hope."

'Things Are Shifting'
Some posters described how ETFs have become key building blocks for their portfolios.

"After 30 years of investing in mutual funds only, I started buying stocks about three years ago and then began buying ETFs about two years ago," said bobr44. "I still buy mutual funds, but ETFs allow me to buy or sell intraday and in many cases offer lower fees than the closest equivalent mutual fund. Also, some of the unique 'pseudo-indexes' that exist with ETFs are not duplicated in mutual funds."

"[The] main benefit for me is low cost and transparent fund types that make it easier to construct a well-rounded portfolio," said John883. "Many online brokers have automated methods to reinvest dividend payments while avoiding transaction costs."

Tuk1010 wrote, "I'm continuing a process of replacing all mutual fund holdings with ETFs for two primary reasons: 1. Their significantly lower fees. 2. In trading like stocks, one doesn't have to wait 24 hours to learn what price they paid or received in executing a trade, as is the case with mutual funds. That said, I'm still mostly invested in mutual funds partly as a legacy of my accounts and partly because I'm betting on some managers to beat the market. But things are shifting."

Like tuk1010, mickeg cited the fact that ETFs provide greater control over trading prices than traditional mutual funds do.

"[I] have approximately 55% of my holdings in conventional mutual funds, 45% in ETFs or cash equivalents," mickeg said. "As time goes on, the proportion devoted to conventional funds will slowly decline and the proportion to ETFs will increase. ... I have never liked the idea of ... not finding out until the end of the day what I actually paid for [a conventional mutual fund] or sold it at. I recognize that this is really a small issue. But I am the type of person that actually looks at the prices on a restaurant menu before I order and I look at the bill before I pay it. I can specify what I am willing to pay for X number of shares of an ETF with a limit order."

ETFs also tend to be more tax-efficient than traditional mutual funds, a fact not lost on several readers.

"[We] have transitioned our taxable account to exclusively ETFs," Mobellus wrote. "We also use them about 20% in our non-taxable accounts. Everything is buy-and-hold, but the taxable account is the primary source of our charitable contributions. ETFs are as easy to gift as appreciated stock and we replenish each year's contributions with cash that is invested in sectors/regions/indexes that are discounted or represent good value at the time of purchase--to be held at least one year to be eligible for donation at a future date. Last year it was Indonesia and emerging markets in general that got the cash infusion."

Dragonpat uses a similar approach, writing, "All my taxable account assets are in ETFs; no more capital gains distributions from mutual funds I have to pay taxes on yearly. ETFs are easier to donate to charity than mutual fund shares. I use ETFs in my Roth and 401(k) mostly for sector investing (energy, utilities, gold, single-country like Australia, etc.)."

'I Still Find Mutual Funds a Better Fit for Me'
But not everyone was completely sold on the advantages of ETFs. Grumpy, for one, predicted that the increasing use of ETFs might create opportunities for actively managed funds, the vast majority of which are traditional mutual funds.

"I use a mix of ETFs and actively managed funds (guess this line is blurring but still holds for now). Sometimes there is no substitute for an active, knowledgeable manager. I also think that, as more investors use ETFs, returns will become more mediocre, active managers will have an easier time achieving better returns, and the pendulum will swing back toward active managers," grumpy said.

Another dissenting voice was artsdoc, who wrote, "I prefer using mutual funds but will use equity ETFs if there are no alternatives. I prefer Vanguard products so if I have a brokerage account at Schwab or Fidelity, I'll buy a Vanguard ETF and hold it. I don't use ETFs if there will be regular contributions because of the sometimes unpredictable bid-ask spreads and occasional fees. I used to buy bond ETFs but have liquidated all of them; the dividends were invested many days after the record date and the reinvestment prices were too unpredictable. The longer I've invested assets, the less enamored I am of ETFs. And if I'm using ETFs that have mutual fund equivalents in the same firm there are no tax advantages. All in all, I still find mutual funds a better fit for me."