How Exchange-Traded Funds can Harm Your Portfolio

May 16, 2011

Exchange-traded funds (ETFs) are in high demand. According to the Investment Company Institute, ETFs surpassed one trillion in assets, increasing in dollars held by 31% for the year ending March 2011.

 

With this level of growth, some advisors are predicting ETFs will eventually replace traditional mutual funds entirely. Meanwhile, others believe they encourage speculation due to intraday trading and brokerages fighting to bring investors to their own in-house commission-free offerings. ETFs have a few features you should be aware of before adding them to your existing portfolio.

 

One important factor is the relationship between ETF settlement dates as they relate to the other investments in your portfolio. ETFs are transacted like stocks on stock market exchanges. Due to that fact, a potential problem comes into play with different settlement time periods for various types of investments.

 

Most traditional mutual funds will settle on the next business day (known as T+1) after an investor places a transaction (assuming the transaction is placed during normal business hours, and before a fund company’s cut-off time). This means that when you sell a traditional mutual fund, you can generally withdraw or transact your money again on the business day after you place the sale. Stocks and ETFs on the other hand settle on the third business day (T+3) from the date the transaction is placed. Because of this, there is a possible delay in being able to move from one investment vehicle to another.

 

Let’s say you hold the Vanguard Emerging Markets ETF (NYSE: VWO) which you want to sell and add to a current position in the Vanguard 500 Index (VFINX) mutual fund. You place a sale of the ETF on a Monday to settle on Thursday. The earliest that the order can be placed to buy the 500 Index is Wednesday in order for the settled funds to be available on Thursday. If VWO or VFINX has increased since the time you placed the sale until Wednesdays close, then you’ve missed out.

 

The problem only applies in this scenario, since in the reverse – where you trade the mutual fund for the ETF – the fund settles before the ETF, and the ETF purchase can be placed alongside the fund sale. Many brokerages will allow you to place offsetting transactions for a buy and sale of securities that settle on the same day. So a swap of one ETF for another ETF may not require waiting until the sale (first transaction) is settled before placing a buy, since settlement of the cash in the sale occurs on the same date as the buy. (Call your broker to confirm this is true on your account, as not all investment houses will allow individual investors to trade in unsettled funds.)

 

The time gap may not sound like a lot but being out of the market for two days can have a material effect on a portfolios performance, and if done regularly the results can add up. A swing of just 2% over the days out of the market on a $50,000 transaction means you missed out on $1,000 of investment gain – a substantial cost for wanting to participate in today’s ETF craze.

 

The preceding blog was originally published by Forbes. To view the original blog please visit our blog at Forbes. http://www.forbes.com/sites/feeonlyplanner/

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