Tuesday, July 2, 2013

Drawing the Line on Exchange Traded Funds

Drawing the Line on Exchange Traded Funds

Generally speaking, I’m a fan of the Exchange Traded Fund (ETF) as a worthy and useful competitor to the mutual fund.  An ETF is a trust that trades on a stock exchange.  The trust represents an investment in a collection of stocks or bonds, such as the components of the S&P 500 or the small cap Russell 2000.  As a traded security, the ETF enables an investor to better control the timing and tax treatment of an investment than a mutual fund.  By contrast, a mutual fund can only be bought or sold at the closing price at 4:00 pm, and the mutual fund’s tax liability generated by trading is passed on to investors. 

Like most financial products, ETFs are subject to abuse.  Because ETFs can be traded on exchanges, they tend to encourage speculators and day traders.  Moreover, Wall Street has created a variety of ETFs that have excessive expenses and too narrowly defined purposes.  Moreover, some of these more esoteric ETFs have limited liquidity and thus are subject to significant trading costs.  However, for those of us who favor long-term index investing, the ETF is a useful and low cost tool.

The purveyors of ETFs are clamoring to get their funds included in 401(K) and State College Savings programs.  Obviously, they are hoping to tap new markets for their products.  Is the ETF good for 401(K) and State College Savings Plans?  In my view, the answer is, no.  First, the ability to control one’s tax liability doesn’t factor into either program; they are after all tax-deferred programs.  Second, the liquidity feature (the ability to trade all day long) is completely inappropriate.  Folks who trade in their 401(K)s are merely driving up their expenses and driving down the probability that they’ll have enough money to retire.

In my experience, senior executives like to dabble in their 401(K)s.  Most of them aren’t relying on these accounts to retire, so they like to be able to speculate with their accounts.  As a result, they’ll probably encourage their human resources departments to add ETFs to the 401(K) line up.  As far as I am concerned, executives should be spending their time managing the business, instead of puttering around with their 401(K)s.

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