Exchange Traded Funds: A Retirement Saver’s Best Friend

Posted on December 6, 2013 at 8:57 AM PDT by

Exchange traded funds, now widely held among investors both big and small, have gotten something of a reputation as keen trading tools.

A fair number of investors like the idea of being able to buy a slice of the Dow Transports or a chunk of the real estate business with an eye toward dumping the position in short order. Exchange traded funds, known as ETFs, offer that kind of exposure.

exchange traded funds

Which is fine, if trading is your goal. The retirement saver, however, should look at exchange traded funds for what they offer in terms of cost, predictability and total return.

Here are some key points to consider when building a serious retirement portfolio:

1. Cost is paramount

The major reason to chose exchange traded funds over active mutual funds is cost. Most active funds charge well over 1% in fund management fees and pass along the underlying costs of funds they buy and commissions they pay.

The resulting hit is a large part of the reason the majority of funds fail to beat the benchmarks, year after year. Underperformance is virtually guaranteed.

2. Looking for indexing power

You should never buy an exchange traded fund thinking, “Stocks will go up.” Rather, you should be seeking exposure to the possibility of an increase at the lowest possible cost.

Doing so provides your portfolio with a return very near the results of the actual indexes, which have shown time and again to be the most reliable sources of long-term investment gain.

3. Careful with tracking error

Some ETFs try to replicate narrow slices of a given investment type by replicated the return artificially, often using complex derivatives and futures to model an index.

That can result in wide gaps between an ETF and the index it purports to represent. Stick with broadly held, long-only exchange traded funds to avoid this trap.

4. Liquidity is vital

Index fund owners typically  buy in order to hold for long periods. If you plan to rebalance frequently, an ETF can give you the power to buy and sell with ease, often commission-free.

Be sure to own the most widely held ETFs, however. Small ETFS that are less liquid can result in wider “bid-ask” spreads, the gap between the sell and buy price, introducing unplanned costs into your portfolio.

5. Check your emotions

By far the most useful features of exchange traded funds is their impersonality. There’s no manager to follow, no corporate backstory or C-suite drama to fret over.

For traders, that can seem a disadvantage. For long-term retirement savers, however, reducing emotional ties to an investment is the key to long-term gains. The less you invest personally into a stock, the more likely you are to sell at appropriate times.