Stern Advice: Read this before jumping on the ETF bandwagon

WASHINGTON (Reuters) - Some stories just seem to end up in the cosmic consciousness: blogged, tweeted and talked about in many different places at the same time. Right now, one of those story lines involves the big smackdown between traditional mutual funds and ETFs.

Investors look at a computer screen supplying stock market information about listed companies on the stock exchange September 15, 2010. REUTERS/Caren Firouz

Several analysts have raised the idea that traditional mutual funds are dying and the future belongs to ETFs, which look like index funds but trade like stocks.

“Mutual funds lose their battle with ETFs,” MarketWatch columnist Chuck Jaffe wrote, “War is over.”

There’s a bit of statistical evidence that he is right. Since the end of 2007, some $155.4 billion has been withdrawn from stock mutual funds while $231 billion has been invested in stock ETFs, according to Lipper, a ThomsonReuters research unit.

The number of ETFs and assets in them have exploded in the year ended May 31, reports investment adviser BlackRock Inc, with assets growing 38 percent to $984 billion, and the number of ETFs growing 21 percent to 1,008.

But still -- all of the ETF assets put together make up less than 10 percent of the assets in traditional mutual funds, says Lipper. And all those people who claim “funds are dead” probably haven’t peered into your fund-stuffed 401(k) or rollover IRA lately.

Now that the fast-money traders have embraced ETFs, the question for most individual investors is this: Should you follow suit? And if so, how do you take a portfolio that’s been invested in mutual funds and move it into ETFs without getting slammed by the tax man?

Here are some thoughts.

-- ETFs are usually cheaper in many ways. They tend to have lower management costs, lower internal transaction costs (because they aren’t constantly buying and selling shares of underlying securities to deploy new investments and meet redemptions) and lower taxable distributions, says David Hultstrom, Woodstock, Georgia, adviser. Over the long haul, that can make a big difference in the amount of money you accumulate.

-- Retirement issues are tricky. ETFs have been thought ill-suited for 401(k)s and any other accounts where money is contributed in small and regular amounts. That’s because there are transaction costs involved in buying ETFs, and those fixed costs can be a high percentage of a small contribution.

But now, new research reveals that, even with transaction costs included, ETFs can beat traditional index mutual funds. That’s because the transaction costs are quite low -- roughly 7 cents per share or less, according to Lincoln Trust Company, which administers 401(k) accounts.

The firm recently compared the performance of ETFs and index mutual funds following the same indexes. It found that once a contribution is allowed to stay invested for 16 months, the ETF beat the index fund returns. So workers looking long term in their company-sponsored retirement accounts could accumulate greater sums by switching to low-cost ETFs.

-- Share price matters when you’re investing in ETFs through a retirement fund. Say, for example, you’re paying 7 cents a share to invest a $100 weekly contribution. If the price is $50 a share, you’ll pay 14 cents in transaction costs for every $100 you invest. If the share price is $5, you’ll pay $1.40. That makes a big difference.

-- ETFs offer protection. You can put a stop-loss order on an ETF, telling your broker to sell if the price falls below a certain level. You can’t do that with a mutual fund, points out Tom Roseen of Lipper.

-- Liquidity matters. An ETF which follows a broad stock market index might not present problems, but one which has a narrow niche can end up with a sizable spread between its buy and sell price when the market is going after, or ditching, the underlying assets. That makes advisers like Tim Kober of Cedar Financial Advisors avoid ETFs that focus on thinly traded or illiquid assets.

-- Bond ETFs are not as popular. The wholesale rush into stock ETFs hasn’t been seen on the bond side, where there’s less than 6 cents in ETFs for every dollar in bond funds. That could be because of the liquidity issues.

-- You have to manage the tax hit. When you sell a winning mutual fund to transfer money into a less expensive ETF, you can end up with a sizable taxable gain. That might be okay, says Kent R. Addis, Jr., a Wayne, Pennsylvania, money manager. Capital gains tax rates may be at a low now, so that could work to the advantage of investors.

Do the math to see how long it would take the cheaper ETF to make up for that tax hit. One wrinkle: Vanguard Investment ETFs are considered a share class of their index funds, says Kober, so you can switch out of the fund and into the ETF without it being a taxable event.

(The Personal Finance column appears weekly. Linda Stern can be reached at linda.stern(at)

Editing by Chelsea Emery