Why ETFs Are Bad For Buy & Hold Passive Investors?

An Exchange Traded Fund, or ETF, is a form of a mutual fund that trades on stock exchanges much like stocks. ETFs started in 1993 and have gained a lot of popularity in recent years. One of the biggest reasons for ETFs popularity is that you can trade them easily and throughout the day, which you can't do with mutual funds. ETFs generally have lower expense ratios and costs than their counterparts in mutual funds. Unlike mutual funds, you do not need any minimums to purchase ETFs.

Lastly, ETFs are more tax efficient. When an investor sells shares of an ETF, those shares exchange hands with buyers. For every seller of an ETF, there is generally a buyer of that ETF. Because of this, capital gains generated by ETFs are minimal. In contrast, when an investor sells shares of mutual funds, the mutual fund managers may (depending on their cash cushion) end up selling the underlying securities, which results in capital gains taxes. Due to this reason, ETFs are believed to be more tax efficient than mutual funds.

HOWEVER, in my personal view, ETFs ARE NOT GOOD for buy and hold investors even when you account for above benefits.

Trading commissions on ETFs is one of the most obviously ignored cost. Every time you buy or sell ETFs, you have to pay commision fees to the brokerage firm. This costs varies but can range from as little as $2 to as high as $10, and even more in some cases. This cost is per transaction of a particular ETF. If you trade more than one ETF, then your transactional costs multiply.

Also, trading commissions on ETFs can do damage in non-obvious ways. The commission costs will negate the tax efficiency of ETFs and may even eat into your ROI. BUT, more importantly, because every transaction involves costs, they will prevent you from dollar-cost-averaging your purchases.

Commission costs will subtly force you into becoming an active trader. Instead of buying periodically, regardless how the market does, costs will force you to wait for opportune moments to time the market to save money on commissions. Because you are timing the market, emotions will often get into the way and will cloud your buy and sell decisions. Read Psychology of Active Trading.

These days, many of the mutual fund houses (example, Shwab, Vanguard) now offer commission free ETF trades if you buy ETFs from their family of ETFs. Sometimes, you need to have certain minimums to get commission-free trades.This is well and good because you will now save money on the commissions cost.

However, ETFs STILL suffer from one more huge disadvantage in that they are NOT automatic. You have to remind yourself and make the effort to buy them at regular frequencies to dollar-cost-average your purchases. If you are not disciplined, you can easily forget to do this. When it is automatic, you simply relax and focus on other productive activities.

Last point, I will mention would be that brokerage accounts are designed to make money for the brokerage firms. That is why they offer tools like real time market dashboards, stock screening tools, hot tips, and webinars. All these tools are there to subtly invite you into trading stocks and ETFs on their platform. Very soon, you will be hooked on to these tools and will be  thinking about the ups and downs of the market.  AND, time after time, study after study suggests that active trading under performs passive forms of investing. This is why I believe in passive investing using index funds.

To prove my points above on commission costs, here is an example of costs comparing Vanguard S&P 500 ETF against S&P 500 mutual fund.

	S&P 500 ETF	S&P 500 Index Fund
Initial Investment	$3000	$3000
Expense Ratio	$0.05	$0.16
Commission	$3/trade	NONE
Increment Investment	$100/month	$100/month
Holding Period	10 years	10 years

 

[caption id="attachment_249" align="alignnone" width="281"] Vanguard S&P 500 ETF vs S&P 500 Index Fund Cost Comparisons[/caption]

[caption id="attachment_250" align="alignnone" width="300"] Vanguard S&P 500 ETF vs S&P 500 Index Fund 2012 Returns After Capital Gains and Distributions Comparison[/caption]