ETFs: A Friend to Young Investors

Not long ago, the only option for investors looking for simple diversification in their portfolios was to buy a mutual fund. Individual stocks have always required a large amount of capital to be properly diversified, but mutual funds were famous for offering a low-cost, quick-and-easy way to manage risk in your portfolio. But today, there is a lower-cost more tax-friendly option. With the rise of discount brokers, investors can now add diversification to their portfolios via low cost. ETFs. Here are a few of the reason why exchange traded funds are the friend of the young investor.

DAILY PRICING

Unlike mutual funds, exchange traded funds, actually trade in real time like stocks. ETF’s 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 AND TAXES

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 have an expense ratio of 1%. That doesn’t include funds with 5.75% sales charges.

The average ETF has an expense ratio of just 0.5%. There are even some Vanguard ETFs with expenses as low as 0.18%.

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.