Are the mutual fund's days numbered?

By Penelope Wang, senior writerJune 21, 2010: 2:26 PM ET
(Money Magazine) -- Ever since exchange-traded funds were created in
the early 1990s, they've been seen as a threat to old-fashioned mutual
funds. That's because ETFs can offer you instant exposure to a wide
range of investments -- from the broad stock and bond markets to
individual sectors to niche strategies -- all with a single trade.

At the same time, they're not as likely to expose you to as big a tax
hit as a traditional fund, and they're often a cheaper bet. The
Vanguard Total Stock Market ETF, for instance, charges annual fees
that are less than half of what its mutual fund sibling levies. To top
it off, ETFs can be bought and sold throughout the trading day, just
as stocks can. Traditional funds can be bought or sold only once daily
at the closing price.

Yet despite these advantages, ETFs have always come with a major
drawback. For as long as they've been around, you've had to pay
commissions to a brokerage anytime you bought or sold these shares. So
if you invest small amounts monthly, those charges could swamp the
other cost advantages of an ETF.

But that's starting to change. In May, Vanguard said it would lift
commissions on trades for all 46 of the ETFs it runs. That follows
recent moves at Fidelity, which started offering commission-free
trades for 25 BlackRock iShares ETFs, and at Schwab, which removed
trading fees on its line of ETFs in November.

*Advantage: ETFs*
Even before this development, there were plenty of signs that ETFs had
been gaining ground. "With commissions going away, ETFs will gain
market share over funds even more quickly," says Princeton economics
professor Burton Malkiel, author of _A Random Walk Down Wall Street_
(who also founded an ETF provider). That's because investors will
start to wonder if they really even need to own traditional funds

Well, do you? Probably not -- at least if you plan to invest in
broad-based ETFs. Those that track established benchmarks like the S&P
500 or the MSCI EAFE index of foreign stocks tend to be dirt cheap.
For example, the average ETF that follows a U.S. broad market index
charges just 0.36% in annual fees, vs. 0.66% for similar mutual funds.
Also, if you make frequent trades or if you rebalance a multifund
portfolio often -- say, at least twice a year -- you don't need
traditional funds anymore. And if you like to place bets on individual
sectors, like technology or health care, commission-free ETFs would
seem to make a lot of sense now. After all, you can invest in the
Technology Select Sector SPDR ETF for 0.21% a year, while the typical
tech-sector fund charges 1.6%.

The risk, of course, is that you can easily get carried away and
narrow-cast your portfolio into oblivion. These days you can find ETFs
that give you exposure to such fare as North American multimedia
companies and Japanese small-cap dividend-paying stocks. Start to play
too many hunches and you may be better off just going to the track.

*What you need to know*
Even if you don't have a gambling problem, there are certain things to
keep in mind with ETFs.
For starters, while it may make sense to put new money to work in
them, converting an existing portfolio of funds may not be
cost-effective, since you'll take a tax hit on your gains. (There's an
exception: If you're a Vanguard index fund investor, you can convert
to the ETF class of the same portfolio, if there is one, without
incurring taxes.)

Also, few 401(k) retirement plans currently offer ETFs as investment
options. And while the overall number of ETFs is growing, if you're
looking for one that invests in both stocks and bonds, or a portfolio
managed by a stock picker, you'll probably find few choices that fit
your goals.

Another thing to keep in mind: If you have a small account or rarely
trade, you could incur other fees. At Vanguard, if your balances slip
below $50,000, you'll be assessed a $7 to $25 fee per trade on
non-Vanguard ETFs and stocks.

Finally, you have to understand how ETFs work. Like any other
investment, they come with their own set of complications.

*1. Don't go too exotic*
Normally, there's a gap between the price buyers are willing to pay
and what sellers will accept for ETF shares. Think of this as an
additional expense you have to pay.
For ETFs that invest in widely traded investments, such as S&P 500
stocks, this so-called bid/ask spread may be only a few hundredths of
a percentage point. But for less frequently traded assets, the spread
can be two or three points or more. And that's on a regular day.
In the "flash crash" of May 6, when the Dow plunged nearly 1,000
points in just a few minutes before climbing back, the exchanges ended
up canceling thousands of orders, two-thirds of them involving ETFs,
where there was a 60% gap or more between trades.

Many involved specialized ETFs, such as those that invest in specific
sectors or themes. To be fair, ETFs that track the broad market were
also affected. Still, in general it's best to play it safe by sticking
with broad-market ETFs where this spread is normally narrow.

*2. Make sure your EFT is tracking its index*
The point of an index fund is for it to perform almost exactly as the
benchmark does, since that's what you're paying for. Yet iShares MSCI
Emerging Markets ETF lagged its index by six percentage points in

This is what's known as tracking error. It occurs in all sorts of
ETFs, but can be more pronounced in those that invest in less
frequently traded securities, says investment adviser Rick Ferri,
author of The ETF Book. If your ETF consistently misses its mark --
you can check by looking up its performance and that of its index on -- consider switching to a different one or going with
a traditional fund.

*3. Be careful with commodities*
While stock index ETFs are often tax-efficient, be aware that other
types of ETFs, like those that invest in commodity futures, can
generate sizable taxable gains. Also, ETFs that hold physical
commodities, such as SPDR Gold Shares, are taxed as collectibles, so
you'll pay a 28% rate on profits, not the 15% rate on long-term
capital gains.

If you plan to invest in these types of ETFs, do it through an IRA.
That way, you'll keep more of the returns you earn. With commissions
going away, isn't that why you want an ETF in the first place?
Source: CNN.Com