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ETFs: Get to Know Exchange-traded Funds

Exchange-traded funds (ETFs) are bundles of securities you buy or sell on a stock market in a single transaction. Learn more about ETFs and how to invest.

An exchange-traded fund (ETF) is a diversified investment product that can be bought and sold in shares on the stock market in the same way you can buy and sell shares of stock in an individual public company. When you buy a single share of an ETF, you can invest in hundreds of stocks, bonds or other securities all at once.

WHY INVEST IN ETFs?

The problem with buying individual stocks is that for most individual investors, holding a small number of stocks is too risky: a problem with one company in your portfolio could easily wipe out gains from all the others. Diversifying your investments by owning a mix of hundreds of different securities helps spread out your risk. Unfortunately, creating a properly diversified portfolio with individual stocks takes capital that most individuals don’t have. Which is why mutual funds were invented.

Mutual funds are famous for offering a low-cost, quick-and-easy way to manage risk in your portfolio. But mutual funds aren’t perfect. Mutual funds have minimum investment requirements and charge hefty management fees. Some funds  place restrictions on when you can sell shares. In addition, most mutual funds are constantly trading the stocks and bonds that make up the fund. This creates capital gains taxes that reduce your rate of return.

ETFs provide a more tax-efficient and — often — lower cost alternative to mutual funds. Here are a few of the reason why exchange-traded funds are worth considering:

DAILY PRICING

Unlike mutual funds, ETFs actually trade in real time like stocks. ETFs give investors the advantage of timing their buy and sell transactions. You have control over what price to enter a position and what price to exit a position.

That’s the problem with mutual funds: you have absolutely no control over the price in which you are buying shares. Mutual fund prices are only calculated once a day. The net asset value (NAV) is computed at 4pm Monday to Friday. This makes it difficult to take advantage of great buying opportunities.

Remember when the Dow tanked over 900 points in one day? You could have taken advantage of the market crash by buying an index ETF at a discounted price. If you wanted to invest in a mutual fund when the Dow was tanking, you would have had to wait. It’s highly likely that the fund manager would not have even picked up your shares the same day, causing you to miss out on a great investment opportunity.

LOWER FEES

ETFs often have much lower fees associated with them than mutual funds. Lots of actively managed funds have management fees, load fees, and sales charges. A really great mutual fund will still have an expense ratio of 1 percent. That doesn’t include funds with 5.75 percent sales charges. The average ETF has an expense ratio of just 0.5 percent. There are even some Vanguard ETFs with expenses as low as 0.18 percent.

TAX EFFICIENCY

Another advantage of exchange-traded funds is that they are more tax efficient than mutual funds. Mutual fund managers will often trade in and out of a position throughout the year thus subjecting their investors to higher tax fees. ETFs have less portfolio turnover so investors will have lower short term capital gain taxes. ETFs are even more efficient for index investing. Why buy an index fund when you can buy an index ETF and lower your expenses?

LOW MINIMUMS

Younger investors with less cash can start investing in an ETF today without worrying about having enough cash to meet account minimums. Actively managed funds have higher account minimums to invest than exchange-traded funds do. For example, most Vanguard mutual funds require a minimum investment of $3,000 just to invest. Some Vanguard funds require as much as $10,000. T. Rowe Price Funds require a minimum investment of $2,500. Even fund companies with lower minimums typically require at least $1,000. ETFs are easier to invest in because they require no minimum investment. Investors just have to pony up the price of 1 share to start investing.

FLEXIBILITY

Although not advised, investors can aggressively trade exchange-traded funds. You can buy and sell as often as you wish in an ETF. The same is not true of mutual funds. Mutual funds don’t permit active trading. If you try to do this with your mutual fund, expect a letter about your aggressive trading practices from your fund company. ETF’s also allow you to place limit orders and sell shares short. While not recommended, you can even buy shares on margin.

I am not suggesting that you should dump all of your mutual funds. There are some good mutual funds out there that outperform the market and are worth the extra expense. However, most investors that are looking for broad diversification amongst sectors or indices should give ETFs a look.

Comments

  1. Another great post, Mark.

    What I especially like about ETFs is that many have an inverse (i.e. FAS / FAZ). So, traders who aren’t comfortable with the concept of shorting (or are prohibited from doing so by their brokers) can still capitalize on downward movements in the market.

    While I’ve not invested in ETFs, that benefit alone is what keeps ETFs on my “to learn more about” list.

    • Thanks Adam! That is true. They have to be careful with ETF’s like FAZ and FAS. They can move against you very rapidly.

  2. The beauty of ETF is that it appeals to a large variety of investors.Like exchange traded funds (ETFs) that they are about to launch for the first time in the country, Benchmark Mutual Fund are a new name for most investors in the mutual fund industry

  3. A couple of notes here. First, your comparison of fees isn’t 1-to-1. You compare fees for actively managed mutual funds to those of ETFs, which by and large follow indexes (though this is unfortunately starting to change). It would be much more accurate to compare the fees to comparable index mutual funds. You will find that the difference is much smaller, and in some cases non-existent, with that comparison. For example, at Vanguard, the Total Stock Market fund expense ratio starts at 0.18% and drops to 0.06% if you have enough invested. Their ETF expense ratio is 0.06%. So when comparing apples to apples, there may or may not be an advantage for ETFs. But I would certainly agree with the point that investors should largely invest in good index-tracking products, whether ETFs or mutual funds, as opposed to actively managed funds.

    Second, while it is true that ETFs can be more tax efficient, it is not always the case. Again, when comparing to comparable index funds, the difference in tax efficiency can be negligible, though ETFs will certainly sometimes have an advantage. There are ways that index funds can manage their trading that can promote a high level of tax efficiency as well. Again, Vanguard is very good at this. Active funds, however, will often be extremely tax-inefficient, but again a comparison of ETFs to active funds is a comparison of apples to oranges.

    Third, when considering costs, you also have to consider the trading costs, namely the bid-ask spread. ETFs can trade at either a discount or premium to their NAV, which can potentially lose you money. Mutual funds always trade at NAV, so this is not a concern. While you certainly have more control over your trading price with an ETF, that control can come at a cost.

    Finally, for many investors, mutual funds are simply an easier tool. If you want to invest in a particular index and you’re trying to decide between the ETF or the mutual fund, the convenience of the mutual fund may be enough to carry the day. Automatic transactions are much easier with a mutual fund, as are reinvestment of dividends. Setting just these two things to happen automatically can have a MUCH bigger positive impact on your investments than saving and extra 0.1% in expense ratio.

    All in all, an informative and useful article. Thank you for the interesting read. Just wanted to present readers with some alternative viewpoints.

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