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Are ETFs Bad for Investors?

From time to time I see financial writers lamenting the explosion in ETF popularity over the last few years. They complain that the original idea of index investing (i.e., buying and holding a low-cost, diversified portfolio) has been perverted in favor of a focus on trading ETFs for short-term profits.

Frankly, I disagree. I think the proliferation of ETFs has, on the whole, been great for investors.

(Quick note: I’m not arguing that ETFs are better than the index funds that already existed. Nor am I saying that most investors should be buying ETFs on margin, day trading them, or buying sector-specific ETFs.)

More Access to Low-Cost Investments

A couple decades ago, pretty much the only way to build an indexed portfolio was to have an account at Vanguard. Today, anybody with a discount brokerage account has access to the tools with which to put together a low-cost, diversified portfolio.

Is that bad for investors?

Price Competition

Over the last year or so:

  • Schwab created their own commission-free ETFs,
  • Fidelity responded by working out a deal with iShares to offer commission free trades on iShares ETFs, and
  • Vanguard eventually replied by allowing for commission-free trades of Vanguard ETFs.

It’s price competition in action, and I doubt it would have happened if it weren’t for the massive demand for ETFs.

Is that bad for investors?

Cost Awareness

We’re naturally cost-conscious in most areas of their lives. We do our best to save money on groceries, utility bills, back to school supplies — everything. Everything, that is, except for investments.

For decades, investors have been paying through the nose for mutual fund portfolios. And we’ve been doing it without even realizing it.

That’s finally changing. More and more investors are becoming cost-conscious about their portfolios. And ETFs are (at least in part) to thank for that.

For example, when Fidelity and Schwab each promoted their commission-free ETFs, they promoted the low-cost aspect of it. There were full-page adds in financial magazines encouraging investors to pay attention to expense ratios and commissions per trade.

Is that really so bad?

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Comments

  1. Originally, I wasn’t a huge fan of ETF’s. The biggest reason was because most index investors don’t invest all at once. They dollar cost average little by little, into the market each month. Therefore, why pay the $10 a month to a brokerage house when you can invest through the mutual fund company for free.

    As I see more companies coming out with commission free investments, ETF’s are beginning to gain more and more popularity. I see no problem in that. They can be a cheaper way, for many people to invest.

  2. I think competition is usually great. of course, commission-free is great! As an infrequent trader, and a rather passive investor (and Professional Portfolio Manager), I love etfs. The lower the fees, the better….. and commissions today are so cheap, they almost don’t matter- especially when making a large investment. Thanks for an awesome site. Best regards, Barb

  3. There do seem to be a lot of ‘exotic’ ETFs listed in the US, with rather bizarre holdings and higher total expenses. I think that’s part of the complaint, too — that what started as simple Total Market funds have become ways to bet on sectors or themes.

    Although perhaps that comes down to a preconception of what an ETF should be. Short, leveraged ETFs are dynamite in most hands, but again a useful tool for those who know (or believe they know) what they’re doing.

    Perhaps as ever the problem is one of education, and human biases.

    Show someone a more complicated investment, and usually they’ll choose it over a simpler one. You don’t buy a simple Nokia phone or a second-hand PC, do you? People have a lot of trouble leaving that mental bias behind when investing.

  4. I am a big fan of ETF’s. I feel that they are a lot more convenient for investors because they do not require a minimum investment amount and list their prices daily. Only the best mutual funds are worth the additional expenses.

  5. Belmont Thornton says:

    I am a fan of ETF as they provide me with the option of a lower expense ratio than those of the average mutual fund.

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