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Pros and cons of ETFs
ETFs can play a big role in your savings plan. But there are a few factors you need to consider.
By Walter Updegrave, Money Magazine senior editor
October 20 2006: 2:29 PM EDT
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NEW YORK (Money) -- Question: My wife and I are both in our early 30s and fall within the 33% tax bracket. We contribute the max to our savings plans at work as well as our IRAs. We also have a taxable brokerage account with a few stocks, but would like to invest about $30,000 a year to this account. Should we consider building an ETF portfolio, or maybe buying tax-exempt municipal bond funds? - Jason Forro, Dewitt, Michigan

Answer: First, let me congratulate you and your wife for getting an early start on your retirement planning and for your diligent savings effort. If you keep this up, you should be able to retire in comfort when you're ready to call it a career.

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But enough with the kudos. Let's get down to your questions, starting with the muni bond query since that's the simplest. You and your wife are young, so you don't need to invest a very large percentage of your long-term investment portfolio in bonds, maybe 20% tops. And whatever you do invest in bonds, you're probably better off doing through your 401(k) or IRA accounts.

Why? Well, bonds and bond funds throw off regular interest payments and tax payments each year would drag down your return.

If you hold those bonds in a tax-deferred account like a 401(k), 403(b) or IRA, however, you postpone paying tax until you withdraw the money, preferably at retirement. This allows your bonds' interest payments to grow a long time without the drag of taxes, which boosts your return over the long term. (See a more detailed discussion of why it usually pays to hold your bond investments in tax-deferred accounts.)

How to use ETFs
Now, as to whether or not you should build an ETF portfolio outside your workplace savings accounts, the answer isn't quite as cut and dried.

Overall, I'm a fan of ETFs. They tend to have very low operating expenses; they track an index or benchmark, so you know what you're getting; and, because of their unique way of creating and redeeming shares, they tend to be very tax-efficient.

That said, they do have some downsides. One is that you've got to pay a brokerage commission. If you're investing small amounts of money, this can wipe out their low-expense edge.

And while I think ETFs are a terrific way to buy a broad swath of the market, the trend among purveyors of ETFs is to churn out ETFs aimed at narrower and narrower slices of the market: the tech sector, semiconductors, energy stocks, even gold, silver and commodities.

I'm all for choices. But I think this can tempt individual investors to make bets on specific sectors or jump around from one sector to another.

That would be just fine if you had a good chance of catching each one before it took off, bailing out at its peak and then moving on to the next one poised for gains. But history shows that many investors end up doing the opposite - they end up buying high and selling low.

All of which is to say that if by "building" an ETF portfolio you mean trading ETFs to generate short-term gains, then I'd have to advise you against doing this.

If, on the other hand, by building an ETF portfolio you mean creating a portfolio that represents a balanced mix of different types of stocks (and, possibly, bonds) that you intend to hold for the long-term, then my answer is a definite "maybe."

Why only maybe? Well, as I mentioned earlier, there's this matter of brokerage fees. You say you plan on investing $30,000 a year. Presumably you won't invest this all at once and you won't put it in one ETF. So let's assume you invest your 30 grand in monthly installments, or $2,500 a month. And let's assume you're investing in two ETFs each time. That means an investment of $1,250 a month in two ETFs.

Screener: Find the right ETF for you
Even if you pay a low online commission of $10 for each purchase, that still amounts to 0.8% of the price. If the ETF has annual expenses of, say, 0.20% per year, a brokerage commission of 0.8% is adding quite a bit in cost.

So does your ETF plan make sense? If you plan to hold your ETFs a long time, I'd say it's pretty much a toss up (time helps because you spread out costs over many years). But I think you could probably do just as well investing in low-cost index funds. If you plan to invest more money each time you buy an ETF, then ETFs become more attractive, although, to be quite frank, I don't think anyone is seriously disadvantaging themselves by sticking to index mutual funds, no matter how much money they're investing.

So if your heart is really set on ETFs, I'd say go ahead, but use them as a long-term investment, not a short-term trading vehicle. Before you shell out money, however, I suggest you read "ETFs: 5 smart strategies," a feature I wrote earlier this year in Money Magazine and "The right way to use ETFs."

And you can also see which ETFs and index funds Money Magazine likes enough to include in its MONEY 65 list of recommended funds.

One final note: while I think it's great you're taking the time to evaluate ETFs vs. index funds, the more important fact is that you're socking away money on a regular basis. Earning a few more basis points in one investment vs. another can marginally increase your wealth. But if you really want to boost your net worth, the single most important thing you can do is save.