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Originally published February 16, 2013 at 8:00 PM | Page modified February 17, 2013 at 9:07 AM

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Chuck Jaffe: Funds or ETFs or neither?

Syndicated columnist

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The tried and true, and boring, method is still the best. Diversify within asset... MORE
Neither. If I expect QE3, 4, or 5 I might purchase GLD, and exchange-traded gold fund... MORE
"Neither. If I expect QE3, 4, or 5 I might purchase GLD, and exchange-traded gold... MORE

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Your Funds

For many investors, exchange-traded funds still feel like a “new” investment product.

They’re not, as the first U.S. exchange-traded fund, the SPY or Spider – formally known as the Standard & Poor’s 500 ETF – recently celebrated its 20th birthday.

But the passing of that landmark is an interesting milestone because what investors have known of ETFs has changed radically over the last two decades; more important, the perception is likely to be much different over the next two decades, too. At the same time, some common misconceptions persist.

Exchange-traded funds effectively, 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.

Launched on Jan. 29, 1993 with $6.5 million in assets, the SPDR S&P 500 ETF isn’t just the oldest, it’s the biggest, with more than $123 billion in assets.

It is also the most traded, with an average daily trading volume that is nearing 150 million shares.

Today, there are thousands of ETFs totaling almost $2 trillion in assets.

The SPY was quickly followed by other well-known ETFs ranging from “Diamonds” — officially the SPDR Dow Jones Industrial Average ETF (DIA) – to the SPDR Gold Shares (GLD), on to the QQQ, PowerShares Nasdaq 100 Index ETF and many more.

The advantages of the exchange-traded fund were obvious; costs were lower, the structure actually improved tax-efficiency – which was saying something, since the traditional index mutual fund wasn’t the side of the business with unpleasant tax side effects – and it could be traded moment-by-moment.

The misconceptions, however, started there.

For starters, people assumed – and still do – that they were no longer investing in mutual funds.

It’s easy to find investors posting on message boards about how they “gave up on mutual funds” in favor of ETFs.

Technically, ETFs are “exchange-traded mutual funds,” but no one wanted the additional letter or word in the acronym.

The difference between traditional funds and ETFs is not the “mutual,” it’s the framework they’re built on.

In that regard, funds and ETFs are both like cars, just built on a different chassis; the ETF is definitely the sleeker, more streamlined vehicle, but just as the sports car is not right for every driver, neither is the ETF.

Moreover, most investors will find a place for both in their holdings, whether that is by their choice or by dint of being involved in retirement programs where the structure of the traditional fund – the ability to buy in without transaction costs and share-class options that allow employers to mitigate the expense of offering a plan – will keep it in the mix for several more decades.

Because both types of funds can co-exist, and in the same portfolio, investors should avoid falling for the assumption that the ETF structure somehow makes their results “better.”

That might apply if you are looking at identical assets – a traditional index fund compared to a lower-cost ETF on the same index ETF, for example – but mutual funds of all stripes are “garbage in, garbage out” investments, meaning that an ETF built on a wonky index or in an out-of-favor sector is going to get hammered every bit as much as a traditional fund with the same trash.

If ETFs have a performance edge, it comes from lower costs, not from some inherent advantage in what goes into them.

That’s important to remember as the ETF world begins the next evolution, toward actively managed funds, where the underlying fund will only be as good as the manager, and a bad manager will make for a bad ETF just as surely as they can now make for a bad traditional fund.

Traditional fund investors had their misconceptions too, namely that because ETFs were built to be traded that they somehow pushed investors to trade.

Indeed, the high average daily volume of the original Spider shows that the ETFs fit into trading strategies; there also are some ETFs – most notably leveraged funds – that aren’t really built to be held for any length of time that can be measured beyond hours.

But buy-and-hold index fund investors know that holding an ETF doesn’t force them into trading; they can make their own long-term strategy more efficient by simply holding ETFs and capturing the cost savings while others trade around them.

Going forward, however, expect more ETFs that, unlike the Spider, don’t really serve both the pro and the do-it-yourselfer.

Industry watchers said there will be one group of ETFs that cover the most granular niche-oriented strategies – allowing investors to focus on, say, the market in Sri Lanka or on companies that make refrigerated dairy products – as well as trading strategies like leverage, and then a different type of fund, including active management, built for the average mid- to long-range investor who wants to use the most cost-efficient structure.

With the 20th birthday party for the ETF now over, the hope is that investors can get off of the question of “Funds or ETFs?” and onto the matter that should have mattered all along, namely “What kind of assets do I want, and where can I get them?”

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright, 2013, MarketWatch

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