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ASK CARRIE- Do ETFs Mean the End of Traditional Mutual Funds? PDF Print E-mail
Written by CARRIE SCHWABPOMERANTZ, Creators Syndicate   
Wednesday, 17 November 2010 21:54

There can be no denying that exchange-traded funds (ETFs) have shown explosive growth and have become an important part of the investment landscape.

However, the fact is that traditional mutual funds outnumber ETFs about 10 to 1. According to the Investment Company Institute, at the end of 2009, there were 8,624 mutual funds available to American investors versus about 820 different ETFs (up from only two in 1995). So even though ETFs are clearly growing in number, in my view, mutual funds are nowhere near extinction. I will highlight how ETFs differ from mutual funds — and how both can help you achieve your investment goals.

ETFS & INDEX FUNDS: MATCH THE MARKET

As I'm sure you know, mutual funds come in two basic flavors. Actively managed funds seek to outperform the markets by superior stock selection or by looking for opportunities to exploit inefficiencies in the markets. On the other hand, index funds simply seek tomatch the performance of an unmanaged index.

For the most part, ETFs function like index mutual funds. Actively managed ETFs are starting to appear, but the vast majority aimto passively replicate a particular market or sector index.

However, unlike a traditional mutual fund — which you can only buy or sell at the end of the trading session — you can trade an ETF throughout the day like a stock, and they also tend to be much more tax efficient. Some brokerage firms waive commissions for trading certain ETFs, but not all.

Both index mutual funds and ETFs are good instruments for low-cost, diversified exposure to the broad market or to specific segments. And given this, both can be great tools for implementing an asset allocation strategy.As I have said in this column before, your asset allocation — the mixture of equities (U.S. and international), fixed income and cash — is crucial to portfolio performance. Choosing between ETFs and index funds really depends on how frequently you trade and how important tax efficiency is to you, but either instrument can help you get the exposure you want.

ACTIVE FUNDS: THE GOAL IS TO BEAT THE MARKET

If you believe in the idea that "a rising tide lifts all boats," then index funds or ETFs are a good choice. When markets go up, indexes and ETFs should go up accordingly (and of course when markets decline, even a diversified index fund will follow suit). But if you believe in the potential of out performance, then you'll need to consider active portfolio management — which, for most individual investors, means actively managed funds. A mixture of both can work well for many investors.

But choosing between index funds (traditional or ETFs) and actively managed funds shouldn't just be based on your belief in the potential of outperformance. You should also think about the additional expense of active management (check the fund's expense ratio) and the amount of risk the fund manager takes in pursuit of that performance.

MUTUAL FUNDS: CENTRAL TO 401(K) INVESTING

Another part of my belief in the long-term health of mutual funds is the fact that they represent the cornerstone of most 401(k) and other employer-sponsored defined contribution plans.Assets in 401(k) plans represent the lion's share of invested assets in the United States, and few 401(k)s include ETFs on the menu of investment choices. Given this, it's hard to imagine that mutual funds will go away anytime soon.

The good news is that investors have many choices when it comes to building their portfolios, from individual stocks and actively traded mutual funds to index funds and ETFs. Yes, it's good to understand the differences and to choose the instrument that makes sense for your situation. But it's even more important to focus on the really big decisions: understanding your goals, your tolerance for risk and the asset allocation that reflects those factors.

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation. You can e-mail Carrie at This e-mail address is being protected from spambots. You need JavaScript enabled to view it . .

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