Fed up with fees? Try ETFs

Personal Finance

November 14, 2006|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

Roseann, a reader from Baltimore, says the investment returns on her mutual funds are being eaten up by fees. She complained to her financial adviser, who recommended exchange-traded funds, or ETFs. Roseann says she doesn't know much about ETFs. But she's interested in getting more from the mutual funds that make up one-third of her nest egg. What are ETFs? she recently called to ask. And what are the pros and cons?

ETFs are basically index mutual funds that trade on an exchange like stocks. The ETF, for example, buys shares in the companies that make up a benchmark, like the Standard & Poor's 500 index. Investors can buy and sell their stake in the ETF throughout the day. Mutual funds, on the other hand, can be traded only once a day.

Exchange-traded funds were introduced in the early 1990s. Now they number around 350, with dozens more set to come on line soon, said Dan Culloton, a senior mutual fund analyst with Morningstar Inc. Early ETFs tracked broad indexes, but now you can find ETFs for specific sectors, countries or commodities.

And some recent entrants don't track an index at all. Gold ETFs, for example, actually own gold bullion. "One share of an ETF is a fractional share of gold bars stored in London banks," Culloton said.

Fees are low because most ETFs passively mimic an index. So not much work there.

"However, as ETFs have strayed from the broadly diversified indexes into esoterica, their prices have also increased," Culloton said. Annual fees can range from about 0.07 percent to 0.90 percent, Culloton said. Still, that's cheaper than many conventional mutual funds, he added.

Besides low fees, ETFs are tax-efficient. Indexes don't change their makeup often, so ETFs aren't frequently switching securities and generating taxable capital gains. And you generally won't recognize capital gains until you sell your ETF for a profit. That's not the case with mutual funds that can pass on capital gains annually to all its investors.

One drawback is commissions. Like a stock, every time you buy or sell an ETF - even if it is to rebalance your portfolio - you pay a sales fee. This has been a hurdle for small shareholders who regularly invest modest sums.

Some online brokerages are trying to make it less pricey for small investors. TD Ameritrade, for instance, launched Amerivest, which charges investors with less than $100,000 an annual fee of 0.50 percent no matter how much they buy or sell ETFs. (Amerivest also makes ETF recommendations based on an investor's goals and risk tolerance. The service is free at www.amerivest.com.)

An alternative to commissions is to buy index mutual funds that have low fees but no sales charges, experts said.

Another potential drawback is that some ETFs may be too narrowly focused and investors might not get the diversification they need, experts say.

"You have to understand what you're getting and how it fits in your portfolio," said Christopher Brown, a Gaithersburg financial planner.

Questions? Comments? Write personal.finance@baltsun.com.

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