Preparing for Retirement: Exchange-Traded Funds (ETFs), Their Benefits and Potential Pitfalls
What Are ETFs?
Popular with many long-term investors and those saving for retirement, exchange-traded funds (ETFs) are securities that invest in a basket of underlying stocks, bonds or other securities—similar to mutual funds. ETFs trade throughout the day on stock exchanges, whereas mutual funds typically trade once per day, after market close.
ETFs can be actively managed—where the ETFs investment manager looks to outperform a specific benchmark—or passively managed—where the ETF tracks the performance of a specific index, market or sector. Since their inception in the early 1990s, ETFs have grown in popularity and are now available across nearly every major market, sector and asset class.
Following is more information on ETFs—including some of the potential benefits and pitfalls—to help you determine if ETFs are right for you.
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Potential Benefits of Investing in ETFs
Many retail investors are attracted to ETFs because of some of the potential benefits they offer relative to other investments. Some of these benefits could include:
- Lower Fees: While costs can vary, ETFs are often less expensive than comparable mutual funds. Further, ETFs usually don’t charge sales loads or 12b-1 fees that are more common with mutual funds.
- Liquidity: ETFs generally offer more liquidity than mutual funds since their shares can be bought and sold throughout the trading day like shares of individual stocks.
- Access to Diversification: ETFs offer a relatively cost efficient way to build a diversified portfolio with less capital. This easy diversification is especially helpful for investors who lack the funding to properly build a diversified portfolio by investing in the individual securities. (But if you have larger amounts to invest, we believe other options may do a better job helping you reach your long-term investing goals. More on that below.)
Potential Pitfalls of Investing in ETFs
Like any investment, there are pros and cons depending on your long-term goals and how you’re investing for retirement. ETFs are no different. We’ve already outlined the benefits above, so now let’s consider some of the limitations, which include:
- Lack of personalization: ETFs are not tailored to your individual investment goals. Accommodating unique needs or desires can be difficult with ETFs. For example, it’s almost impossible to restrict investment in a certain company or type of company when invested in an ETF. If you’re a high net worth investor, you may be better off having a customized portfolio tailored to your preferences and designed to achieve your individual financial goals.
- Tax disadvantages:* Depending on where and how you’re saving for retirement, ETFs can potentially limit your ability to minimize capital gains taxes, an important consideration for some high net worth investors. While ETFs may be more tax efficient than mutual funds, owning individual stocks and other securities can provide high net worth investors greater flexibility in harvesting capital losses. For instance, consider a hypothetical ETF that had a net return of zero in a given year. This ETF has two securities: one experienced significant gains during the year while the other experienced significant losses. An investor in that ETF may not be able to harvest any tax losses if the ETF itself didn’t go down in value; however, if they owned the underlying securities, they may be able harvest tax losses from the security that fell significantly.
- Less cost efficient: Despite ETFs’ lower costs, if you own a larger portfolio, it may be more cost efficient to buy individual stocks and bonds rather than pay the expenses associated with an ETF. With a larger portfolio, even a relatively small fee percentage could end up costing quite a bit.
- Overdiversification or Overconcentration: Diversification is generally a good thing, but only up to a point. If you invest in several ETFs without paying attention to their underlying assets, your asset allocation strategy can be unintentionally derailed if the assets in the funds replicate each other. In other words, too much overlap could lead to overconcentration, which can undermine your carefully constructed asset allocation strategy. To diversify a retirement portfolio, we believe it is necessary to know and understand that each of its components works together to meet your long-term objectives.
A Word on “Passive” Investing and ETFs
Passive investing typically involves holding an investment and avoiding active trading decisions. Commonly, “passive” investors try to find investments that mimic market indexes—such as passive ETFs—with the goal of holding for the longer term. It sounds easy, but many investors who hold passive ETFs often fall victim to emotional decision-making when market volatility hits.
Remaining passive can be incredibly difficult when the market drops precipitously. When that happens, some ETF investors end up trying to time the market, buying ETFs only to sell when they see the market decline. In short, they end up working contrary to their intended passive strategy—actively buying high, abandoning their investments and selling at the wrong time.
A Better Approach
All the available options can make it difficult to determine of ETFs are right for you. This becomes more important as your portfolio grows. If you have a portfolio of $500,000 or more and want a comfortable retirement, we believe you may benefit more from working with an investment adviser who knows your goals and preferences, and must look after your best interests.
Fisher Investments is happy to provide portfolio reviews to qualified investors with $500,000 in investable assets. We can look at the ETFs and other funds you hold and identify overlaps in underlying assets. We can also determine whether you might benefit from direct investments.
Investors who become our clients receive specific asset allocation and investment recommendations aligned with their personalized financial goals, along with world-class client service from our dedicated Investment Counselors.
For more information, request an appointment or learn more about Fisher Investments through one of our many guides.
*The contents of this document shouldn’t be construed as tax advice. Please contact your tax professional.