Personal Finance

More and more advisors are moving their clients into exchange-traded funds, but don't go along without doing your homework.
By Christine Benz | 21/04/15

I received an email from a friend a few weeks back, in which she noted that her advisor was recommending she ditch her portfolio of mutual funds and switch into exchange-traded funds instead. What did I think about that idea?

About the Author
Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success.

As I drafted my response to her, I realized that plenty of other investors are probably wrestling with a similar question. ETFs and other index products have been raking in the assets during the past few years, and much of that asset growth is coming from advisors shifting out of traditional mutual funds.

I didn't give her a yes or no answer. I don't know what's in her portfolio now, what types of ETFs the advisor is recommending, or her tax situation. Most of all, I don't know her advisor. Is he recommending ETFs as a means of bringing down the costs of her total portfolio, or because he'd rather focus his energies on areas where he thinks he can add value, such as tax planning? (Both good reasons.) Or does he plan to employ ETFs to zip in and out of various asset classes--a practice with which professional fund managers have had limited success?

Conducting your own due diligence and asking your advisor about his motivation are essential steps when deciding whether to shift your portfolio into ETFs. Here are the key questions to answer before making a shift.

1) Is at least some of the money in a taxable account?
Yes: If this is the case, switching into ETFs may be more advantageous to you in the long term but could also trigger capital gains taxes when you sell your traditional mutual fund holdings. (Questions 2 and 3 will help you weigh the costs and benefits of switching.)
Near-term advantage: Staying put.
Long-term advantage: Shifting to ETFs.

No: If your money is in tax-sheltered accounts such as an RRSP, you won't incur capital gains if you sell your funds and move into ETFs, but nor will you benefit from the tax advantages of ETFs over time.
Advantage: Neutral.

2) If at least some of your money is in a taxable account, have many of your holdings appreciated since you purchased them?
Yes: Switching into ETFs will trigger a capital gains tax bill, meaning that any future costs and/or tax savings from switching into ETFs must be even greater to offset the near-term tax hit.
Advantage: Staying put.

No: If you don't have significant capital gains or you even have a loss in your holdings since you purchased them, you may more readily realize a benefit -- either by lowering your expense ratios or improving your portfolio's tax efficiency -- by opting for ETFs.
Advantage: Shifting to ETFs.

3) Does your taxable portfolio include a heavy stock component?
Yes: ETFs that track broad stock market indexes tend to be quite tax-efficient relative to actively managed mutual funds, in part because they trade very little and also because they don't need to sell securities to meet shareholder redemptions.
Advantage: Shifting to ETFs.

No: If your portfolio includes a heavy fixed-income component, you'll see less of a tax benefit from shifting into ETFs. That's because the tax treatment of bond income is identical regardless of whether you hold a traditional mutual fund or an ETF.
Advantage: Staying put.

4) Does your portfolio already include a sizable share of traditional stock index funds?
Yes: Although ETFs have historically done a good job of limiting taxable capital gains, particularly relative to actively managed funds, so have traditional broad stock market index funds. Even though low costs are a big selling point of ETFs, good broad-market index funds also have low costs.
Advantage: Staying put.

No: ETFs often have lower costs and better tax efficiency than actively managed funds.
Advantage: Shifting to ETFs.

5) Are the proposed ETFs significantly cheaper than the funds you already own?
Yes: Limiting fund costs is one of the simplest ways to improve your take-home return, and ETFs can be had for less than 0.10% per year. However, be sure to ask your advisor if the switch to ETFs will trigger higher expenses elsewhere. Many advisors who are employing ETFs are moving from a commission-based business model to one where the client pays a percentage of his assets per year for total portfolio management. Get the details on whether and how your advisor's compensation structure is changing as well as an estimate of what your total fees will be relative to what they were before the change.
Advantage: Shifting to ETFs, provided your total portfolio management costs aren't going higher.

No: Even though ETFs are widely touted as low-cost, they're not always cheaper than actively managed funds or even index funds.
Advantage: Staying put.

6) Do you like the idea of investing in flexible funds?
Yes: With few exceptions, most ETFs are index trackers that don't have a lot of latitude to significantly change their composition based on what's happening in the market.
Advantage: Staying put.

No: The fact is, most active managers haven't beaten low-cost, broad-market index funds over time. (The data vary by asset class and time period, and the fact that most managers underperform doesn't rule out the possibility that some active managers will beat their benchmarks.) If you're swayed by that data, you can readily find ETFs to track the major asset classes for a very low price. And because they're targeted rather than flexible, ETFs and other index trackers make it easy to keep tight control of your asset allocation at any given point in time.
Advantage: Shifting to ETFs.

7) Does your advisor have a defensible plan and a proven track record?
Yes: If your advisor is recommending a shift into ETFs as a means of populating a long-term strategic asset-allocation plan with low-cost investments, your plan is likely on sound footing. Among mutual funds that invest in multiple asset classes, those using "buy, hold and rebalance" strategies have generally outperformed vehicles that employ tactical rotations among asset classes. And keeping your overall costs low -- by selecting low-cost investments and trading infrequently -- is one of the best ways to tilt the odds in favour of your plan. Finally, low-maintenance buy-and-hold strategies allow your advisor to focus on areas where he can more readily add value -- managing your investments for maximum tax efficiency, for example, or helping you develop a cash flow strategy for your retirement.
Advantage: Shifting to ETFs.

No: Be on high alert if your advisor wants to employ ETFs because he plans to trade frequently. (In contrast to mutual funds, which can be traded once a day, ETFs can be bought and sold throughout the trading day, just like stocks.) Fast-trading strategies have the potential to increase your tax costs by racking up short-term capital gains. And if your advisor's strategy involves tactical adjustments to your portfolio's asset allocation, ask to see some documentation on his track record with that approach, as such strategies are difficult to pull off consistently.
Advantage: Staying put.

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