U.S.News & World Report
Why You Should Invest in ETFs
Thursday July 31, 12:09 pm ET
By Katy Marquardt


Exchange-traded funds, which share the design of mutual funds but trade on exchanges like stocks, are no fad in the financial world. So far in the United States, ETFs have attracted more than $600 billion in assets. That's tiny compared with the $12 trillion invested in conventional mutual funds, but ETFs are gaining fans quickly.

Tom Lydon, president of the Newport Beach, Calif., firm Global Trends Investments, is one of a growing number of financial advisers who favor ETFs over mutual funds. Lydon, coauthor of a new book, iMoney: Profitable ETF Strategies for Every Investor, and a blogger at ETF Trends, says between 80 percent and 90 percent of his firm's clients now have pure ETF portfolios. Lydon recently spoke to U.S. News about why investors are gravitating to ETFs, where the industry is headed, and which funds to buy now. Excerpts:

Why choose an ETF over a mutual fund? We're seeing more and more investors make that choice, and the big reason is that many individual investors have lost faith and trust in the mutual-fund industry. After a big run-up in the 1990s and a big decline in 2000-02, many investors felt that the fund companies were going to take care of them. But when the S&P 500 declined 47 percent and the Nasdaq declined 75 percent, these mutual funds felt the pain as well.

During this time, investors were calling their fund companies, wanting to hear what their fund manger was doing, and some would say that they're thinking about making a move. Meanwhile, people at the funds were telling them not to time the market, to take a long-term perspective, and they were very much motivated to try to keep people in the funds. Many people lost money.

After that was the mutual-fund scandal. And, finally, the straw that broke the camel's back: After the market declined, analytical firms on Wall Street comparing performance found that between 80 percent and 90 percent of active managers don't beat their benchmarks. With mutual funds not even beating the market, investors are saying, 'If I can't beat the market, I'll buy the market' in the form of ETFs.

Investors like ETFs because they can understand specifically what they're buying. As time goes on and technology and reporting capabilities improve, you'll see more and more advisers and investors shifting money to ETFs. They're not a fad, and they're not going away. We're probably only in the second or third inning. The $600 billion in ETFs assets represents only 5 percent of the overall mutual-fund marketplace.

If you're thinking about making the switch to ETFs, what are the big considerations? First, if a mutual-fund investor looks at their own portfolio, they need to see how their funds have performed versus their benchmarks and what fees they are paying. If mutual funds are underperforming--be it the majority or a handful--they warrant consideration to be sold and replaced with ETFs.

From an allocation standpoint, the vast majority of mutual-fund investors have predominately high allocations to large-cap stocks, and today the S&P 500 is just about where it was 10 years ago, which is unbelievable. Meanwhile, small-caps and mid-caps have drastically outperformed. And the prognosis going forward is that they will probably continue to do so. So if you're overallocated in large caps, or if your mutual funds are underperforming their benchmarks, it's very easy to turn to ETFs. A few sources allow you to plug in your fund holdings and produce a picture of your allocation, including Morningstar and Yahoo Finance.

Although there are about 700 ETFs on the market, a lot have just come out this year. We look for ETFs to have at least $100 million in assets before we invest. Some asset classes, such as small-cap growth, are very well represented, so you have a lot of choices. Since many now have a decent track record, you can compare an ETF to the rest of its asset class. Also, a variety of providers offer ETFs based on conventional market-capitalization-weighted indexes, like the S&P 500. Others, like WisdomTree, offer fundamental indexes based more on earnings or dividends.

What about fees? The average actively managed fund charges fees of 1.57 percent; the average domestic asset-class-based ETF charges between 0.15 percent and 0.20 percent. Granted, there are some fund mangers that have done a great job over the years, and they deserve to continue to attract assets, but that may be only 10 percent of fund managers. So the question is, why are the other 90 percent of funds still attracting dollars?

A big reason is that almost 60 percent of new investor money goes into 401(k)'s, so the next big leap for the ETF industry is 401(k) plans. Unfortunately, we're years away from that, because the big ETF providers are not motivated to allow ETFs within their 401(k) plans. And although some mutual funds have been good performers, some huge 401(k)'s are chock-full of poor-performing mutual-fund choices. But we're seeing some steps being taken. Congress is passing more and more legislation for fund companies and corporations offering 401(k) plans to do a better job of disclosing fees and performance. Eventually, trustees will feel more pressure to cut expenses and provide better fund options. And 401(k) participants like you and I will put more pressure on companies we work for to offer better choices.

How many ETFs should make up a portfolio? Typically, our clients will have 10 to 14 ETFs in a portfolio, and the average portfolio is around $1 million. That's not that many holdings. But when you look at underlying holdings of the indexes, they're very well diversified.

What ETFs do you like, given the current market? One area that has been bucking the trend is biotechnology. Healthcare and biotech have been unloved and haven't had a run-up over the past three years. Also, there are a lot of biotech companies related to agricultural research--looking at better ways of developing seeds, for example--and many top-producing drug companies have patents that are about to expire, so we have a lot of big pharmaceuticals snapping up biotech companies with drugs in the pipeline and great ideas. An ETF I like is iShares Nasdaq Biotechnology Index (symbol IBB).

What do you think of actively managed ETFs? I think they're great. Remember, there are thousands of actively managed mutual funds that charge high fees for poor performance. Actively managed ETFs have much lower fees. There's not a lot of turnover, so you're not going to have the distributions of conventional funds. There is an added tax advantage in ETFs. It's difficult to understand, but because a fund manger doesn't have to sell stocks and raise cash when money goes out of an ETF, the ETF doesn't have the inherent capital-gains exposure that conventional mutual funds have. In addition to low fees, that makes ETFs extremely attractive over the long term. Today, you're not going to see billions of dollars flowing in to active ETFs, but over time--because of the nature of the structure--they're probably going to outperform most of the actively managed conventional funds. These are also the types of ETFs we'll see in 401(k) plans down the road.

What else is new in the ETF industry? One thing we've just seen recently is the introduction of a few frontier ETFs. They represent areas like the Middle East, Eastern Europe, and Africa--markets that you and I wouldn't normally have the opportunity to get into. These pre-emerging markets are starting to develop, and they're embracing global accounting standards, technology, and trade. It's a neat opportunity for investors who missed the whole emerging markets move. This might give them the opportunity, when global markets turn, to be in some of the new, hot areas.