First, let's separate the broad based index ETFs from the leveraged, inverse, niche (the late, unlamented
HealthShares come to mind). As Investor wrote, all but the first are at best, designed for traders.
I meet John Bogle half way in my view of ETFs. Many are a lot of hype, encourage trading, and are not economical, either from an ER perspective, or from a tax perspective. (I'm largely echoing Investor's comment here).
The broad based index ETFs do
mostly live up to their descriptions. They are indeed tax efficient (so long as they are market cap/free float based, or otherwise designed with buffers to reduce turnover). But so are well run, well managed open end index funds tracking the same indexes. (According to its
NYTimes snapshot, the last time Vanguard 500 VFINX made a cap
gains distribution was December 1999.) And in the case of Vanguard ETFs, there's no tax advantage to the ETF share class, because they are just a class of the same portfolio as the open end fund - so any
gains are distributed among all share classes including the ETF share class.
Broad based index ETFs are (generally) low in expenses; but one can often find open end peers with similar ERs. In the case of Vanguard, the Admiral share class (currently) has the same ER as the ETF share class. And both of these tend to be lower than other families' ETFs. EAFE index? EFA (iShares) with its $46B in assets is larger than the rest of the EAFE ETF market. But its 0.34% ER is 70% higher than Fidelity's Spartan International Index (FSIIX's) Fund's 0.20% ER. Even Vanguard's VEA ETF at 0.12% ER costs more than the Advantage share class (FSIVX) of Fidelity's fund. So while ETFs
generally cost less than open end equivalents, it's not a given.
The buy/sell mechanism of ETFs, IMHO is more of a detriment than a benefit (except to traders). There are commissions (unless buying at a broker who sells the particular ETF without commission). One of the benefits of ETFs was supposed to be that you could get them pretty cheap anywhere (you just paid a stock trade commission, as opposed to a mutual fund transaction fee which tends to be much higher). If you're relying on getting free ETF trades (because the ETF is on your broker's NTF list), then this benefit of ETFs goes away.
Aside from the possible commission, there's the bid/ask spread. My understanding is that what matters even more than how widely or thinly traded an ETF is, is how widely traded are its underlying securities. If its portfolio is thinly traded, then authorized participants will have a big overhead in buying up the securities necessary to make a creation unit. That means that even if the market price of the ETF rises above its NAV, the authorized participants won't immediately jump in to create more shares, sell the ETF shares, and move the market price back in line with the NAV. All this, because it costs them money to build that basket of thinly traded securities. Not a problem with, say, and S&P 500 ETF, but could be a problem with international ETFs or ETFs of smaller securities.
This gets us to tracking error. There are a couple of sources of tracking error. One is in the portfolio construction/management. All index funds have this problem - whether they are open end funds, ETFs, or any other structure. How well does the management select securities, time their purchases, manage index changes, etc. to track the index? Beyond that, ETFs have a second source of tracking error - the deviation of market price from NAV as just discussed. Not an issue with open end funds. (Open end funds have a different issue though - cash management - how to deal with cash coming in and out of the fund without mistracking due to variable amounts of cash.)
As negative as I must sound about ETFs, I still use them. When there's an index that I want to get and there's no less expensive alternative (taking into consideration the spread, commission, and time I expect to hold the position). When I'm buying a Vanguard index where the open end version has an entry or exit fee. (For example, VGAVX has a purchase fee of 0.75%, while the ETF share class VWOB is purchased on the stock exchange; both have the same ER).
All else being equal, I'll use open end funds; but all else is not always equal and ETFs can serve a role in a low turnover, broadly diversified personal portfolio.
