There is no doubt that ETFs are less expensive than mutual funds. They are a great many other things that mutual funds are not as well and investors who may now find this tool in their 401(k) plan should know what these big “maybes” are.
An ETFs acts like a mutual fund index. In fact, in may even suggest that it does the same thing. But the ETF may have what is known as a tracking error. This can come due to the attempt by the mutual fund manager to replicate the index they are tracking. The problem arises when they buy, based on weight (a term that refers to the percentage of the portfolio a certain company may hold based on its size). This generates higher fees as a result making the index fund more attractive (particularly if you are focused on the fee aspect of the investment). Granted, the fees will be higher in an ETF that replicates but the tracking error will be less.
Then there are the optimizers, slicing and dicing the index to suit a particular need. These cost more and in many cases are impossible to compare. Once the index is divided into subsets, the ability for the investor to make assumptions based on how they will perform are rendered worthless. While some mutual funds are difficult to compare to index funds, ETFs, which tout themselves as a the cheaper, actively traded cousin shouldn’t be.
And although free is a very good word and ETFs bill their services as being as close to free as is possible. they are far from it. Exchange Traded Funds often have embedded fees that are not always advertised. They may be cheaper than actively traded mutual funds but they are not, in many instances less expensive than index funds.
You need to consider these “maybes” as well. ETFs are volatile and much of the end-of-the-day trading volatility is due to traders piling in and out of these funds. This tends to skew the real value of the product. Inside a 401(k), they can be real trouble and may not be as tax-efficient as index funds can be. (Although I believe that tax-efficiency inside a 401(k) plan is a waste fo potential returns – take risks in your 401(k) and invest in tax-efficient funds outside of your tax-deferred accounts.)
ETFs do provide some broad market exposure but that is hardly the reason you should pursue them at the expense and risk provided by other funds in your plan. If anything, ETFs should be the last choice in your plan, perhaps holding onto less than 10% of your investment dollars. They might be a good way to play increasingly difficult markets such as Europe has become. But in the big picture, this a toy for the pros.
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