One often neglected investing area here at Buy Like Buffett is ETF investing. I may write an occasional post about exhange traded funds but not frequently enough. Well, today we have a real treat as a financial blogging friend of mine has written a good article on investing in ETF’s. I love those Dummies book by the way. They are great! (The following guest post was written by MoneyCone who runs a How To blog on personal finance and investing at MoneyCone.)
ETFs have become extremely popular providing instant diversification at a relatively low cost. Unlike mutual funds, there are no minimum requirements and you can trade an ETF like regular stocks. There are over 900 ETFs trading in various exchanges in the US.
When picking a stock, there are standard parameters (P/E, PEG, P/B, P/S) one can use to determine if a stock is overpriced. What about ETFs? Although they trade like stocks, the parameters for ETFs are different. How Can you tell if you are overpaying for an ETF?
Let’s look at two ETFs that track the MSCI for emerging markets. EEM and VWO. Though both track the same index, the underlying assets are different, thus there will be slight variations in the returns.
VWO has returned 56.31%
EEM has returned 57.38% over the past 5 years.
So, which is the better buy?
Look at expense ratios
The expense ratio is the annual cost of maintaining the ETF. So if you invested $10,000 in an ETF with an expense ratio of 0.50%, $50 goes towards running the fund every year. This cost is already factored into the price of the ETF. If you want to make money investing then buy funds with low expense ratios.
VWO has an expense ratio of 0.27% which is actually pretty good for an international ETF. The expense ratio for EEM is more than twice that of VWO at 0.72%. VWO is more attractive when comparing expense ratios.
Don’t pay more for an ETF than you should
One very crucial parameter that separates an ETF from a stock is the Net Asset Value(NAV). This represents the total value of the ETF’s underlying assets. The NAV divided by the number of shares gives you the fair value of the ETF. If you pay less than the fair value, you are buying the ETF at a discount and if you pay more, you are paying a premium. Always look to buy at a discount or at low premiums.
EEM trades at a premium of 0.13% and VWO trades at a premium of 0.34%.
Look for ETFs that have low bid-ask spreads
For every seller there needs to be a buyer and vice versa (That’s why it is called a stock ‘market’!). Bid is the price at which someone is willing to buy a security and and ask is the price at which they are willing to sell. The difference is called the spread. Buy ETFs that have a low bid/ask spread.
VWO has a 0% bid/ask spread and EEM has a bid/ask spread of 0.02%. Both are very negligible in this case.
Commissions
Unlike mutual funds, ETFs incur trading fees each time you buy or sell. Keep this in mind when buying or selling ETFs frequently. A $7 commission for buying $100 worth of ETFs is simply not worth the investment! Commissions, of course are determined by your stock broker and will be the same for both ETFs.
These are some simple guidelines one can use when dealing with ETFs. Also note that ETFs come in different varieties. The above guidelines are for ‘vanilla’ ETFs and not exotic ETFs like the leveraged kind. Leveraged ETF’s are only appropriate for professional traders.
So, what do you think? Do you prefer ETF investing over stock investing or mutual fund investing? Which ones are better for regular investors to make money?
I prefer ETF over mutual fund because the fee is lower. I also think individual stock investing has a place in my portfolio. I only follow a few stocks so I can keep track of them.
Good ETF overview. I have VWO.
I think that’s why ETF investing is starting to impact the mutual fund market…the fees.
I’ve been looking at an ETF for a while, largely because all of my money is sitting in the stock market right now. I want to mix it up a bit, without going to the mutual funds route (just yet)
Pick ETFs with low expense ratios, have a good asset mix of stocks and bonds, rebalance regularly, have a long investment horizon and you’ll beat most of the fund managers.
I primarily invest in ETFs myself. I do prefer them over mutual funds because of the low MERs and the ability to get in and out of them very quickly whenever I want. I also prefer them over stocks because I don’t have the necessary knowledge or time to stock pick. I will buy the occasional stock but doing so is the exception, not the rule for me.
I don’t invest in ETF, but would like to. I just bought this book – ETF handbook to read more about it so that I can start investing. I am still confused about the advantages everyone quotes. I get the low fees and relative ease of trading, but I have seen people mentioning about tax advantage. I tried to read more about it but not sure how it is more advantageous to buy ETFs than MFs. Is ETFs really better than MF for tax purposes? Or did I read some bad articles?
Suba, when you hold a mutual fund, you can incur taxes even if you don’t sell a single share if the fund company decides to redeem underlying shares of the fund for cash. This can happen when a number of investors decide to sell the mutual fund at the same time forcing the fund company to raise cash beyond their reserves.
With an ETF, you pay taxes (or write off loss) only when you sell your ETF, like ordinary shares.
ETFs can incur capital gains distributions just like mutual funds, but not from redemptions since whenever someone sells there is always another party buying your share of the basket of stocks held by the ETF. Since most ETFs are passive index funds they are unlikely to distribute capital gains, but changes in the makeup of an index can trigger capital gains or losses, as well as some types of mergers and acquisitions. Of course, you will also have dividends each years to put on your tax returns.
Don’t forget there are active ETFs too. And their active trading will incur capital gains just like a mutual fund.
Vanguard and Schwab sell some commission free ETFs.
ETFs can generate capgains, but this is very minimal for non-exotic, index based ETFs and shouldn’t be the reason to not consider ETFs!
Suba, to understand what the capgains/losses are compare Turnover Ratio of one ETF with another ETF or a mutual fund which should give you a rough idea what this entails.
That’s a good summary.
Excellent post! I would point out that commission free ETFs are available and becoming more available so look for those also to compare with when selecting a particular asset category.
I absolutely agree with your advice to, all other things being equal, buy the ETF with the lower expense ratio. John Bogle has done a good job of demonstrating that expense ratios are one of the major factors determining your portfolio’s balance.
I’m a little confused by your advice to buy ETFs trading at par or at a discount to NAV. I thought the Authorized Representative system ensured that, for us ordinary investors, an ETF’s NAV will never vary much from its market price. I the best ETF covering the type of investment I want to fill in the asset allocation of my portfolio, and that’s it. Often there isn’t a choice. Where there is, I do look at the assets and the index followed, and then at the expense ratio.
The only advantage mutual funds have over ETFs is when somebody is investing by having small amounts of money deducted from their paychecks. They cannot pay a $7 commission out of every paycheck.
However, I say it’s better for people in that situation to have their funds go to a money market account. When they’ve accumulated enough to a round lot of their desire ETF, do so. If it takes months, it takes months. At least they earn a little interest while waiting.
Actively traded mutual funds should be avoided at all times, because you’ll pay a performance penalty on top of the fund expense fees. You’ll help make the manager rich even though, in the long run, they’ll do no better than anybody else could have.
CapitaRetail China Trust
Richard, the system is set up to stabilize wide price fluctuations that are not in par with the NAV, that does not mean it is a given.
For instance, during the May flash crash, a number of ETFs lost more 60% of their value trading at a discount.
IWF, lost 99% of its value!
Of course, the flash crash is not an everyday event, but something one should be aware of.
I’m still a novice in these areas but need to shape up as am looking at getting into investing in 2012…… Thanks for the informative post.
You’re welcome Forest!