Three Misconceptions About ETFs

February 5th at 10:49am by Tom Lydon

The exchange traded fund industry has been around for 20 years and touts about $2 trillion in total assets under management. However, these trading tools are still misunderstood by some, due to common misconceptions.

“Exchange-traded funds were built to be index mutual funds that traded like stocks. Indeed, that is precisely what the original Spider has done over its two decades, even as a lot of its competition took that basic mission in many directions,” Chuck Jaffe wrote for MarketWatch. [SPDR S&P 500 Marks Two Decades of ETF Growth]

Exchange traded funds have many advantages such as tax efficiency, low costs, transparency and flexibility. Some common oversights and misconceptions about the ETF industry have abounded, which may be have some investors weary about the business. Chuck Jaffe points some of them out:

  • By technical definition, an ETF is an exchange traded mutual fund, but nobody wants to call it that. The structure of the fund is what sets an ETF apart from a mutual fund. The ETF is known to be more modern, streamlined and flexible with the ability to trade in real time as a single stock would. Mutual funds and ETFs both have a place in the investment world, and can compliment one another within an investment strategy. [Using ETFs in Asset Allocation Models]
  • If one compares a simple, broad-based ETF such as the SPDR S&P 500 (NYSEArca: SPY) to a mutual fund of the same feather, the ETF may win when it comes to expense ratio and overall return. However, if an ETF is structured around a niche or poorly performing market sector, it will get hammered just the same as the mutual fund. ETFs get touted for performance because of lower costs, which impacts principal, not because of some magic formula. [How to Put Savings to Work With ETFs]
  • Another misconception about ETFs stems from the flexibility of the trade. Since ETFs are easy to trade, some argue that they cause investors to trade too much simply  because they can. Some ETFs are high volume, and some ETFs are meant to be held for only a day, but ETFs are not just for trading. In fact, for some of the low costs of certain ETFs to be realized, they should be held for some length of time in a buy-and-hold strategy. [John Murphy: ETFs Have Revolutionized Trading]

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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