I’ve gotten a couple of calls lately about ETFs (exchange traded funds), which we use in the client portfolios we manage.
ETFs are still the new kids on the block, compared to mutual funds, and clients are a little uncertain about how they work.
“I see I’ve got some Schwab funds in my portfolio,” a client might ask. “Is it safe to put all my money with them?”
Or another might comment on how they would rather not use proprietary funds, remembering how these “in house” mutual funds gave them problems years back when they had an account with a major brokerage firm.
Another young investor we spoke with felt strongly about wanting low cost, passive investments in his account. As it turns out, that’s exactly what he owned, but he didn’t realize it.
The excellent questions and comments we’ve received remind us that many clients are still unfamiliar with ETFs, and we need to spend more time explaining what they are, how they work, and how they can help clients reach their goals.
To kick it off, here’s 5 important things you should know about ETFs and why we use them:
1). What are ETFs? ETFs, or exchange traded funds, are like traditional mutual funds, in that they invest in a basket of stocks or bonds. But unlike mutual funds, they trade constantly during the day. Most are “passive” investments that copy an entire market basket of stocks or bonds (like the S&P 500), without any attempt to select or emphasize “the best” stocks or bonds. “They don’t try to beat the market, they try to be the market,” explain experts at Nasdaq. For this reason, they are often more tax efficient and less costly.
2). Do all ETFs track an index? Many do, but not all. The first generation of ETFs were indeed “passive,” meaning they invested in a broad basket of stocks (or bonds) meant to match the performance of the index they were tracking. Some newer ETFs go beyond pure market-cap weighted indexing and use special strategies to pick and choose investments in hopes of outperforming the overall market.
3). How do we use ETFs? We use both traditional mutual funds and ETFs in the portfolios we manage for clients. There are situations where we prefer to have an experienced, human manager hand-picking investments, so we’ll use an actively managed mutual fund. In other situations, we believe the best approach is to use a low-cost, passive market index, so we’ll use an ETF. That flexibility allows us to deliver focused investment performance to clients at a lower cost.
4). What’s the benefit of using ETFs in your portfolio? ETFs are often lower cost, which helps your bottom line. They are also more tax efficient. ETFs work great when you want to capture the “market” return; for example, when you think a rising tide will lift all boats, and you don’t believe that stock-picking will add additional value.
5). Why do we use ETFs managed by Schwab? In addition to providing brokerage and custodial services, Schwab has become a major player in the ETF market. They offer several stock and bond ETFs which track market indexes. (And by the way, market index ETFs managed by Schwab are very similar to those managed by Vanguard, iShares or any one of a number of other excellent companies).
What makes some of the Schwab ETFs particularly attractive is that they’re available to clients with no buy or sell transaction costs. Plus, Schwab ETFs have some of the lowest expense ratios in the industry with the cost savings flowing directly to your bottom line. Believe it or not, the Schwab U.S. Broad Market ETF costs less than Vanguard’s famously frugal funds, tipping the scales at 0.04% per year (if your math has gotten rusty, for every $10,000 invested, the cost is only $4). You can’t get much cheaper than that! One last advantage is that, unlike the proprietary mutual funds of old, these new ETFs are totally mobile. They can be easily moved from firm to firm, and account to account, just like an individual stock or bond.