ETFs used to be an oddity. Today they’re one of the fastest-growing investment products in the world. In 1993, a solitary Exchange Traded Fund existed. It took two years before another one surfaced. But fifteen years later, according to the Investment Company Institute, the number of ETFs has soared to 697. Plenty of industry insiders don’t expect that momentum to stall.
Why all the fuss? ETFs look a lot like index mutual funds, but they are devoted to many more investing niches.
Each ETF tracks its matching index—and there are many indexes used as benchmarks. The ETF’s collection of underlying stocks or bonds is expected to track its designated index as closely as possible. In fact, most ETFs must maintain a 99 percent correlation to their benchmark.
What makes ETFs different is that they’re traded like stocks. To buy or sell ETF shares, you must place an order through a brokerage firm, just as you would if you wanted to buy shares of any individual stock.
So, what role should ETFs play in your retirement portfolio? The answer might surprise you: None.
At present, most ETFs are not less expensive than the low-cost index funds in my recommended portfolios. In addition, the commissions you incur on ETF purchases will reduce your returns—especially if you buy regularly over an extended period of time. With index funds, you buy directly from the fund family—like Vanguard or Fidelity—without paying any commissions.
Beyond a commission, you’ll also have to pay a bit extra when you buy shares in an ETF, thanks to something called the “bid-ask spread.” This spread refers to the gap between the market price for buying the ETF versus selling the investment. For example, if the bid price is $40 and the ask price is $41.50, the bid-ask spread is $1.50. As a purchaser, you will pay the ask price. The seller receives the bid price. Securities dealers pocket the difference. Because mutual funds aren’t traded as stocks, mutual funds don’t have bid-ask spreads.
ETFs are also less convenient. If you are investing in index funds, you can choose to automatically invest dividends back into the fund. ETFs pay distributions in cash that would likely end up in your brokerage firm account. You’d then have to figure out how to invest the cash.
Some of the much-touted benefits of ETFs are actually a curse. As ETFs gained in popularity, new entrants had to find a different way to distinguish themselves. Big players like Barclays and State Street Global Advisors already had the broadly diversified ETFs covered, so other fund managers aimed for all kinds of oddball niches.
No one needs an ETF that invests in a bunch of cancer research stocks or a bundle of stocks that links its fortunes to maritime ship-pers. The availability of all of these ETF sectors tempts investors to place risky bets they should avoid.
Most investors do not need ETFs in their retirement portfolios.