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5 Ways ETFs Won You Over And Why They Might Not Be Right For You

Richard Satran

Investors' holdings of exchange-traded funds have just passed the $2 trillion mark globally, showing powerful growth at a time when mutual funds are struggling to show any, says a new BlackRock ETP Research report.

There are good reasons ETFs have grown faster than established mutual funds, most importantly their success in beating traditional funds on fees. But this doesn't mean your mutual fund has become obsolete.

Mutual funds still hold $20 trillion globally, and there are compelling reasons to own them. "There is plenty of room for both kinds of funds," says Jeff Tjornehoj, head of research at Lipper. "The growth of ETFs is not necessarily coming at the expense of mutual funds. They are really expanding the market with new alternatives."

Here are five reasons ETFs have won people over so rapidly--and reasons you might still want to keep your mutual funds:

[Read: ETFs vs. Mutual Funds: Which Is Better?]

1. ETFs offer lower fees than mutual funds or owning stock baskets. The cost of investing in exchange-traded funds is between 0.1 percent and 1 percent a year, well below the 0.5 percent to 3 percent charged by managed funds. That difference can add up to tens of thousands of dollars over the life a retirement plan. ETF fees are lower because their structure requires less cost to manage.

Others costs, some hidden: You pay a commission to buy an ETF because it acts much like a stock but owns a basket of funds or other assets. When the value of the ETF fails to follow its benchmark index, it can add additional costs for people buying or selling. The ETF itself has a bid and ask spread, meaning you may might overpay when you buy if demand is strong, or lose money when you sell if it is weak.

2. ETFs are more transparent and open than mutual funds. ETFs are quoted on exchanges and each day, investors can see a complete list of stock holdings of ETFs on various websites. Mutual funds give only their net asset value each day and they list stock holdings only at the end of the fiscal quarter on a delayed basis.

Contrarian view: ETFs list their holdings, to be sure. But they can be involved in many opaque transactions to generate income, such as pay for order flow and stock lending. Not all of it goes to boost the value of the ETF shares.

3. You are investing in an index for the long term. Financial advisers often prefer ETFs because they are an easy, low-cost way to get their clients market exposure compared to stocks or mutual funds. With extremely low annual fees of just 0.05 percent to 0.1 percent, you can own shares of the entire Standard & Poor's 500 index with the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 (IVV), and the Vanguard S&P 500 ETF (VOO).

[Read: How to Narrow Your 401(k) Choices.]

Short term or long term: You might be investing for the long term, but not everyone is. ETFs are a favorite of fast-trading investors. Even the founding father of index fund investing, John Bogle, has been a critic of ETFs because they were designed to trade quickly. This creates short-term price stress and risks for every holder, regardless of investment philosophy. Regulators have also been looking at systemic risks in high-volume ETF trades and the volatility of some exotic new offerings.

4. ETFs don't waste your money on fund managers who most often fail. Since studies show that more than half of managed funds fail to meet their benchmark averages, like the S&P 500 or the Nasdaq index, why pay to lose? Or worse, there is evidence that mediocre fund managers aim to merely "shadow" an index, so you are paying fees to get below-average returns.

Pay for performance: When you buy a mutual fund, you are not paying to be average. To be sure, fund managers take risks and lose many times. But fund managers with proven track records can earn superlative returns. Peter Lynch of Fidelity's Magellan managed 29 percent gains for more than a decade, turning a $20 million fund into $14 billion. No index has ever done that. But if you can avoid "shadow" funds, you might get the market-beating performance you want.

5. You get instant diversity when you buy an ETF. Investors have found ETFs to be a good way to diversify their portfolios. Dodd Kittsley, global head of ETP Research for BlackRock, says the rapid growth of ETFs is from "different assets classes and regions, allowing investors to put [exchange-traded products] to use in new ways." ETFs are widely used to buy physical gold, allowing direct ownership in gold bar certificates in funds like SPDR Gold Trust ETF (GLD). (Note that "ETP" is a slightly broader category than ETF, and includes exchange-traded notes and other ETF-like products.)

[Read: 7 Mutual Funds That Make Huge Bets.]

Limits to diversity: Be careful how you diversify, since some of the more exotic and specialized ETFs are prone to tracking errors, and some have already been closed after failing to win buyers. It's also worth remembering that an equity ETF has a different risk profile than an individual stock, just as a bond fund, with its floating yield, differs from the locked-down yield of an individual bond.

Not better or worse--just different. For investors, there is a basic strategy difference between ETFs and mutual funds.

"Active management has sometimes been trashed because the funds are more expensive. But shockingly, enough when things go badly, active managers have the ability to make decisions that index funds can't make," says Brooks Mosley, president of Security Ballew Wealth Management. "On the flip side, ETFs give investors access to sectors and countries that the average investor didn't have 10 years ago. If you are looking for cost-efficient ways, and not looking for total return, it's better to use an ETF."

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