All About Exchange-Traded Funds (ETFs)

Exchange-traded funds, or ETFs, are sooo hot right now, and with good reason. ETFs allow investors to purchase an entire index with the same convenience and cost of buying a single stock. Are ETFs a wise move for you?

ETFs Defined

The “exchange-traded” part of exchange-traded fund means that investors can buy and sell ETF shares on major stock markets all day long. Unlike individual stocks, however, ETFs hold numerous companies that share a common bond. Stocks comprising an ETF may belong to the same index (like the Dow Jones Industrial Average) or all share the same size and industry (for example, small-cap financial stocks).

Build and Tweak Portfolio Quickly with ETFs

With ETFs, the beginning investor can create a well-diversified portfolio with just a few trades. Although boring, I love (and invest in myself) an ETF that tracks the S&P 500. From there, you can add foreign ETFs to get some international exposure or invest in sectors that you think will prosper without gambling on individual companies.

Change your mind about a certain ETF you bought? No problem, because you can easily sell it on the open market and pay only your broker’s commission.

When ETFs Are Not Ideal

Exchange-traded funds are great for investors—including newbies—who want a low-cost way to invest in broad indexes for the long term. In order to make ETFs cost-effective, though, you really need to be buying larger quantities of shares at one time. For example, you may want to consider buying ETFs if you open a new IRA with a lump sum or do a 401(k) rollover.

• Take Action: Open an IRA Online Now

If, however, you are investing by making small, regular contributions on a regular basis (called dollar-cost-averaging), ETFs won’t work. Trying to use ETFs for dollar-cost-averaging would rack up a ton of trading fees that would outstrip their advantages. Look instead to no-load, low-expense index mutual funds that allow direct investment programs.

Other Differences

ETFs and index mutual funds have other differences, too. For example:

• Taxes: With ETFs, you’re only taxed when you sell your shares.
• Expenses: When any fund sells shares, investors pay for any capital gains taxes through annual expenses. In general, ETFs shed shares less often than mutual funds, meaning fewer capital gains taxes, and lower annual expenses.
• Minimum Investments: Many mutual funds have minimum investments of $2k, $5k, or more, but you can buy an ETF for the cost of a single share. (Note: Many mutual funds waive minimum investments if you are making regular contributions to an IRA account).
• Temptation to Trade: ETFs are so easy to buy, but they’re also easy to trade, which defeats the point of a smart long-term buy-and-hold investing strategy.

If you buy exchange-traded funds in big quantities and hold them for the long term, they are an easy an inexpensive way to build a well-diversified portfolio. Just be careful, as trading commissions can quickly add up if you buy or trade ETFs too often! Finally, don’t forget to do your homework on ETFs that you are considering buying; check their past performance and management just as you would any stock or mutual fund.

Happy investing!

Related Posts

• Mutual Funds: Five Things You Should Know
• Open Your First IRA
• The Top 15 No-Load Mutual Funds for 2009
• The Future of ETFs
• Asset Allocation for Investors Under Thirty