Passive index-based exchange traded funds have helped investors easily and efficiently access broad and niche areas in the marketplace. However, these index funds are not without .
Investors should keep in mind that not all index funds are low cost and tax efficient, and people should not over diversify or become too hands-on with their investments.
For starters, while many index-based funds are cheap and lauded for their low-cost advantage, some may break from the mold.
“In fact, there are a lot of high-cost index funds,” according to Morningstar analyst Mike Rawson. “Index-fund providers–fund companies that are jumping on the bandwagon, seeing all the flows to index funds–might say, ‘Well, if we put the word ‘index’ on this fund, it’s going to attract flows because people just associate indexing with maybe a fair return and low cost,’ but it’s not always the case that index funds are low cost.”
For instance, Rawson points out that there are 53 S&P 500 funds, but the cheapest charge 10-basis points or less. However, there are a number of actively managed funds or large-blend funds with an expense ratio over 1%. Consequently, the advantages of indexing may be canceled out by high fees. [The Various Costs of Trading ETFs]
“So, making the assumption that I’m automatically going to get a low-cost fund if I go with an index is something that people need to be wary of,” Rawson added.
When considering tax efficiencies, investors should keep in mind that index funds and ETFs are subject to the same tax treatment as active funds, and index funds can come with capital gains distributions. However, most don’t issue cap gains as they tend to have low turnover rates. [Why Some ETFs Can Issue Capital Gains Distributions]
Bond funds also tend to be less tax efficient. The funds come with a lot of interest income, which are taxed, and bond ETFs are less able to benefit form the in-kind creation/redemption process since the underlying debt markets are less liquid than the stock market. The bond funds would have to buy and sell bonds more often, leading to higher turnover rates. Consequently, bond ETFs may be more suited for an IRA, or use a municipal bond ETF in a taxable account.
With over 1,600 U.S.-listed ETFs on the market, investors may be tempted to overdiversify with multiple products. However, Rawson suggests investors should focus on one small style-box square or sector or a region. For instance, for the U.S. equity market, an investor can choose a total stock market ETF, which covers a broad swathe of large-, mid- and small-cap U.S. stocks. More active investors can overweight specific sectors with targeted or niche fund picks.
Lastly, investors should refrain from actively or micro-managing their passive funds in an attempt to time the market. Along with accumulating higher trading fees, investors would be losing out on the potential long-term benefits of the cheap passive investments.
For more information on investing in ETFs, visit our ETF 101 category.
Max Chen contributed to this article.