Funds In A Feeding Frenzy

ETFs are fine, says manager William Bernstein. But index funds are better

William J. Bernstein knows a lot about the way the human brain works. But he doesn't understand why the financial community is gaga for exchange-traded funds. The author, money manager -- and neurologist -- has studied the performance of ETFs on his Web site ( Personal Finance Editor Lauren Young recently caught up by e-mail with Bernstein in North Bend, Ore.

What are some of the performance differences between ETFs and index mutual funds?

In each of the seven cases where a direct head-to-head comparison was available, the index fund came out ahead. Almost by definition, this difference must be attributed to differences in trading skills on the part of the fund companies -- that is, the ability to translate the target index into a portfolio.

That said, we're talking about relatively small differences here: Low-cost indexfunds seem to be just a smidgen better. In the long term, both ETFs and index funds are head and shoulders above broker-run accounts, separate accounts, and actively managed mutual funds.

Which asset classes make the most sense for ETF investors?

I'd consider an ETF if I wanted to invest in an asset class for which there was no open-end index fund, such as the S&P MidCap 400 Value Index or the Russell 1000 Growth Index.

In general, I'd stay away from sector and country funds. This applies both to open-end funds and ETFs. It's very hard to play the sector game successfully, and most investors get it wrong. The one exception I'd make is REITs [real estate investment trusts], to which I believe most portfolios should have a relatively small fixed exposure, say, 3% to 6%. The Vanguard and iShares REIT funds have had nearly identical performance over the past three years, so once again the nod goes to the mutual fund because of the absence of commissions.

When don't ETFs make sense?

You shouldn't use ETFs if you're making periodic investments or frequently rebalancing your portfolio. In that case, ETFs are a waste of time and money -- you'll be eaten alive by commissions.

So why is the Street in love with ETFs?

Human nature, pure and simple. People like associating themselves with what's hot. Right now, ETFs are the buzz. I can excuse small investors from falling head over heels for ETFs, but I'm less charitable to financial professionals, who should know how to compare, add, and subtract.

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