Exchange traded funds are becoming a must-have for individual investors, but few of them know exactly what they are, how they work or what makes them different from their mutual fund cousins, advisers observed.
"I don't think most clients can give you an adequate definition of an ETF or a mutual fund," said Brian T. Jones, a certified financial planner and vice president of CJM Wealth Advisers Ltd. in Fairfax, Va. "But they come in saying, 'I need mutual funds. I need ETFs.'"
Sure enough, a recent survey of 500 individual investors by Rydex Investments of Rockville, Md., found that 53% did not know the difference between an ETF and a mutual fund. Thirty-eight percent of those surveyed didn't know what an ETF is.
But now that advertisements for ETFs can be found in general-interest magazines such as The New Yorker, and business publications are publicizing the funds more than ever before, clients are looking for opportunities to join the party, advisers said.
This may call for financial professionals to set aside the ETF-versus-mutual-fund battle and educate clients about the two investment vehicles to help them understand why one or a combination of the two can work for them.
"Advisers can serve a valuable role in helping to educate clients as to how they sift through the morass of mutual funds and ETFs," said Eric Tyson, author of "Mutual Funds for Dummies" (fifth edition, John Wiley & Sons, 2007). Education is a great way for advisers to make themselves valuable to clients, he added.
Acknowledging a need for investor education, Rydex Investments has launched ETF Essentials on its website. The program aims to teach investors and advisers how the vehicles work. But some advisers have found their own ways to approach the problem, regardless of which fund variety they prefer.
Mr. Jones said that although ETFs make more sense for his young and affluent client base, at times the investors need a walk-through of what makes a mutual fund different from an ETF.
"I think you have to educate them out of an investment fiduciary responsibility," he said. "Sometimes you have to do some Investment 101: 'This is a mutual fund. This is an ETF.'"
Ignorance is less of an issue for clients who have upward of $5 million to invest, as they "haven't just fallen out of the turnip truck with no idea of what a mutual fund is," Mr. Jones added.
"We look at actively managed mutual funds against ETFs on a pro and con basis," said Jeffrey E. Daniher, a certified financial planner and co-owner of Ritter Daniher Financial Advisory LLC in Cincinnati. "ETFs usually offer lower expense ratios and better tax efficiency."
On the other hand, an active manager may make picks that vary greatly from a specific index for security selection purposes, meaning investors may get more value but more volatility, Mr. Jones added.
But the ETF industry has also made itself more complicated by adding different options from which investors may choose.
Niche funds make it harder for clients and advisers to compare the two, as "lower fees" is the general mantra of a passively managed ETF, versus an actively managed mutual fund, but specialized funds are more costly, Mr. Tyson said.
Advisers should weigh only similar funds that look at the same benchmarks, noted Daniel R. Solin, a senior vice president of Index Funds Advisors Inc. in Irvine, Calif.
"It's a lot like comparing an apple to an orangutan," said Mr. Solin. "It would be simple to educate clients on the difference of expense ratios, bid-ask spreads and tracking errors, but the discussion gets off track when you compare an ETF that replicates a subasset class to an index fund that doesn't do that."
Another potential problem lies in investors' becoming too cavalier with their ETFs and trading excessively through a discount brokerage ac-count after finding out that the vehicles are priced intraday as are stocks.
"Some people are holding ETFs because of their liquidity, which encourages them to trade more," Mr. Solin said. "We want them to trade less: Trading costs detract from returns."
But advisers reported that this isn't much of a problem with their investors. "Personally, I've never had clients come in and trade more," Mr. Jones said. "You can run into that situation, but maybe those clients are the exception as opposed to the rule."
Advisers report having better conversations with their more educated customers. Those clients can play a more active part in their financial planning, and at times, both parties learn something. A client who wanted to invest in a water utility ETF explained his case to Mr. Daniher after the adviser asked him why the fund was so interesting.
"An open-ended question doesn't challenge investors, but it asks them to share what they're thinking," said Mr. Daniher. "I might be able to have a better conversation about something they overlooked — and it's been known to happen — but sometimes we discuss something I overlooked."
These questions also reveal whether the client has been doing research independently or whether he's hopping aboard something he heard about at a cocktail party.
"We don't keep the knowledge to ourselves," Mr. Daniher added. "We can tell you what time it is, or we can tell you how the clock works."
Darla Mercado can be reached at [email protected].
