This Low-Fee Option Isn’t for Everyone

Exchange-traded funds are the hot spot in the mutual fund market. Popular among investors for their low fees and flexibility, their assets grew 31% last year and an additional 6% in January.

But they are not well suited for everyone. And some experts say their popularity is being fueled by just the sort of people who maybe should avoid them.

“It’s ironic, but ETFs make the least sense for some of the people who are most prone to use them -- small investors who trade a lot,” said Dan Culloton, senior mutual fund analyst with Morningstar Investments in Chicago and author of a new guidebook called the “Morningstar ETFs 100: 2006.”

First launched in 1993, exchange-traded funds started to gain steam only in the last five years. Now there are more than 200 of them, accounting for about $313 billion of the $9-trillion mutual fund industry.

These new investment vehicles are not complicated -- they’re simply mutual funds that trade like stocks. But it’s important to understand their subtleties and how they compare with their closest relative, the index mutual fund.

All of the exchange-traded funds on the market are structured like index mutual funds. They consist of a basket of stocks that reflects a particular market index -- such as the Standard & Poor’s index of 500 U.S. stocks or the Morgan Stanley international index. The fund then holds those stocks, trading them only when component companies of the index change because of merger or bankruptcy.

There are exchange-traded funds for those who want to invest in baskets of big stocks, small stocks, energy stocks, Japanese stocks and so on. If there’s an index, there’s likely to be an exchange-traded fund that mimics it.

Because there’s so little trading within the funds, both index funds and their exchange-traded cousins generate only modest capital gain and dividend payments, limiting investors’ tax exposure, Culloton said.

Exchange-traded funds have an additional tax advantage that can make them a popular choice for people in the highest income tax brackets, said Margie Mullen, a certified financial planner with Mullen Advisory in Los Angeles.

Another advantage: Management fees on exchange-traded funds are low -- on average, about half those charged by nearly identical index mutual funds.

Vanguard, one of the lowest-cost mutual fund companies, offers exchange-traded funds that mirror its index funds, so they’re easy to compare. The annual fee on Vanguard’s exchange-traded Total Stock Market fund is 0.07% -- about $7 annually on a $10,000 investment. Its Total Stock Market Index fund, which invests in an identical portfolio, charges 0.19% -- or $19 for every $10,000 invested.

Vanguard’s Emerging Markets ETF charges 0.3% annually, or $30 for every $10,000 invested; and its Emerging Market mutual fund charges 0.45%, or $45 annually on $10,000.

But there’s a catch.

An index fund can be purchased directly from the mutual fund company, with no trading costs associated with the purchase or sale. Exchange-traded funds, however, are bought and sold through brokers, just like individual stocks, and that can impose trading costs from about $25 at a discount brokerage to more than $100 at a full-service brokerage. What’s more, you pay brokerage fees both when getting in and when getting out.

The bottom line: For a small investor, the trading costs overwhelm the savings from investing in exchange-traded funds, unless the investor leaves the money alone for years. The funds can make sense for bigger investors -- those with tens of thousands of dollars -- as long as they trade sparingly and through discount brokers.

“ETFs are great if you have a sizable amount to invest and you’re going to buy and hold,” said John Demming, a Vanguard spokesman. “But if you’re trading, the cost advantage gets eaten up pretty quickly.”

One aspect of ETFs that many investors like is that they can be bought or sold at any time of the day. Index funds, on the other hand, are traded just once a day -- at the end of the day. Investors cashing out of a traditional index fund get the net asset value at the close of trading. If they’re buying and the market goes up after they put in their order, they pay more; if they’re selling and the market goes down, they get less for their shares.

“That’s one thing that annoys me about trading mutual funds,” said Jim Huller, president of Maximum Wealth Advisors in Roanoke, Ind. “You start the day knowing what the value is, but you are not going to know the price you got until 24 hours later.”

With exchange-traded funds, transactions are completed in minutes, as with stocks, which makes it possible to take advantage of temporary price swings.

But that also makes it tempting to trade the funds more often than a traditional mutual fund, Culloton said, which is exactly what you shouldn’t do.

Because of brokerage fees, exchange-traded funds are also a bad choice for investors who do dollar-cost averaging -- buying a fixed dollar amount of shares every month regardless of price fluctuations. That strategy would run up fees.

“It’s all about costs,” Mullen said.

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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes.com/kristof.