Review & Outlook

Our take on the investing, financial, & economic themes of the day

When should you use ETFs in your portfolio?

13 October, 2010 by Ben O'Brien in Commentary

A client asked recently why own individual stocks when you could just buy ETFs(exchange traded funds)? The following are my thoughts on ETFs: What are they? What are the advantages and disadvantages of owning them?

ETF’s draw their existence from the power of the computer; they could not have existed in the pre-computer day. Now they are popular because they have a number of structural advantages over mutual funds. In fact they are quickly replacing mutual funds. One big advantage is their tax efficiency. Mutual funds are tax inefficient; every year mutual funds must distribute their capital gains and losses to shareholders – – even if the shareholder has not sold the mutual fund. But owning ETF’s, like owning individual stocks and bonds, has no tax consequences. Thus they have the advantage of “tax efficiency” just as owning individual stocks and bonds have the same advantage. Also, as compared to mutual funds, ETF’s tend to have lower fees (though not as low individual stocks and bonds – – which have no on-going fees). Another reason to own ETFs is that they make it very easy to speculate. Thus in a fraction of a second, one can own all junk bonds, or all drug stocks, or all the oil companies. This kind of speculating now goes by the name of “macro-investing.”

How about us? We think ETFs are appropriate for international investing and this is how we use them. But we don’t use them for owning American stocks and bonds. Why not? The problem with the typical ETF, in our opinion, is that by definition you are buying every single stock or bond in a given sector or market – – thus you are buying the good along with the bad. Who wants to own bad stocks and bonds? We try to own just the good ones. As regards their utility in speculating, we don’t speculate or engage in so-called macro-investing. We are long-term holders so this feature of ETFs (their ease in buying or selling large swaths of the market) has no advantage for us.