The answer is not as simple. There is not a perfect choice for everyone. Each investor has their own comfort level and investing style based on their experience, goals and advice from other financial professionals. My vehicle of choice, and the funds I most often recommend for my clients, are exchange-traded funds (ETFs).
ETFs are unique in that they offer instant diversification, daily liquidity, complete transparency, tax efficiency and most important, low fees. No other investment in the world offers this same mix of features to retail investors in such an easy-to-access format.
The first ETF debuted in 1993 as the SPDR S&P 500 ETF (SPY) which tracks the well-known large-cap S&P 500 Index. Twenty years later, SPY has nearly $130 billion of the total $1.5 trillion ETF industry assets. The two next largest funds on the list are the SPDR Gold Shares (GLD) with $62 billion in assets and the Vanguard Emerging Markets (VWO) with $58 billion. Together those three funds represent 17% of the total ETF assets here in the U.S.
There are currently 1,234 funds available from 38 different providers, but the marketplace is dominated by the top three providers. Blackrock, State Street, and Vanguard control approximately 83% of the U.S.-listed ETF market.
Benefit 1 - Diversification: ETFs are essentially a basket of stocks, bonds or commodities that trade on an exchange and are continually priced throughout the day. Most ETFs are designed to replicate an underlying passive index. Therefore, they achieve diversification by investing in the same securities as the index. There are broad-based ETFs that invest in 5,000 stocks and select industry ETFs that invest in 20 stocks. In both examples, you get instant pinpoint access to a diversified strategy or sector with a single fund.
Benefit 2 - Daily Liquidity: One of the drawbacks to investing in an open-ended mutual fund is that they are only priced once a day. With an ETF, you are able to trade in or out of the fund at any point throughout the trading day. This gives you the flexibility to choose your entry or exit strategy based on your needs.
However, some ETFs are more liquid than others, given their underlying holdings and daily trading volume. You should always closely monitor the bid/ask spread when trading ETFs to ensure that you are going to receive the execution that you desire. I always recommend that you consider a fund with more than 100,000 shares of daily trading volume to ensure there is adequate liquidity to fill your order.
Benefit 3 - Transparency: Another drawback with open-ended mutual funds is real-time access to their underlying holdings. Often times, you don't know exactly what the fund is invested in until it releases its quarterly or annual reports. With an ETF, the fund provider is required to post its holdings to its website and give you almost real-time access to the securities and weightings within the portfolio. This is a huge advantage, especially for actively managed ETFs that change their asset allocation at a moment's notice.
Benefit 4 - Tax Efficiency: Because the majority of ETFs passively track an established index, they do not have a great deal of turnover in their portfolios. This leads to a very minimal tax impact at the end of the year when the funds are required to report their long and short-term capital gains. For investors with taxable accounts, this can be a huge advantage in their long-term investment strategy.
Benefit 5 - Low Cost: The internal expenses for ETFs generally range anywhere from 0.05% to over 2.00% annually. Recent industry data suggests that the average ETF expense ratio is 0.61% according to Morningstar. Traditionally you would pay at least twice that for an actively managed mutual fund equivalent. In addition, ETFs do not charge front or back loaded sales charges, 12b-1 fees, or any other hidden expenses. This makes ETFs extremely cost effective to own for long periods of time and ensure that you aren't paying exorbitant expenses.
You will have to pay your broker a transaction fee to purchase or sell an ETF on your behalf, which is generally less than $20 per trade. In addition, you should always research the expense ratios of comparable ETFs to ensure you are purchasing one that gives you the best bang for your buck.
Benefit 6 - Risk Management: ETFs are just like a stock, in that your broker will allow you to place a stop loss on the holding to guard against downside risk. This is another big advantage over mutual funds that do not allow automatic sell orders. I always recommend a trailing stop loss when entering a new ETF position so that you define your risk and are not susceptible to a steep decline.
The Other Side of the Coin
While I believe that ETFs are an excellent tool for your portfolio, there are some drawbacks to using these funds instead of individual stocks, bonds or mutual funds.
Often, the benefit of diversification can work against investors who want to access the best company within a certain sector. For example, in 2012 Apple Inc. (AAPL) gained an impressive 32.57% while the PowerShares QQQ (QQQ) only returned 18.10%. Apple makes up a large percentage of the NASDAQ-100 index that QQQ follows, but other stocks within the index were not able to keep pace with its rapid growth.
Another drawback to using ETFs over mutual funds is that there are certain actively managed strategies that cannot be duplicated in the ETF format. Often, actively managed mutual funds that employ options or other sophisticated trading strategies are not able to carry that same methodology to an ETF because of regulatory or other restrictions. There are still many mutual fund managers that add alpha over their passively managed ETF counterparts. One such example is the Doubleline Core Fixed Income Fund (DBLFX) managed by Jeffrey Gundlach that had a total return of 8.18% in 2012 versus the iShares Aggregate Bond Fund (AGG) return of 3.76%.
The Final Word
While there is no perfect investment vehicle for everyone, I believe that ETFs represent the future of investing. We are continuing to see fund flows out of mutual funds and other investments into ETFs. In addition, we are seeing the ETF industry continue to innovate by releasing new indexes, strategies and products to meet the demands of investors around the world.