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What Is An Exchange Traded Fund?
An exchange-traded fund (ETF) is an investment that is composed like a mutual fund but trades like a stock. It offers the advantage of owning a diverse group of individual stocks or bonds. But it allows an investor to trade the ETF anytime of day as long as the markets are open.
ETFs are low-cost. The average exchange-traded fund keeps its fees to less than .50% compared to the average mutual fund which charges 1.33%. This provides a huge cost advantage to its investors. Some ETFs charge fees lower than .10% which is a real benefit to investors.
Most exchange-traded funds are index-based. This means they track an industry index such as the S&P 500. The main indexes are established benchmarks of stocks or bonds. They were developed to offer a benchmark with which mutual funds could compare their performance.
You can get a lot of diversification by tracking a benchmark. This is opposed to owning stocks. An ETF has the advantage over stocks by being so diversified. This diversification translates into less volatility and less risk than owning only a few stocks.
An ETF is structured so that it can be traded whenever the markets are open. Therefore, you can buy at the current price the ETF is trading for at that moment. You can place a buy or sell order for a mutual fund during the day but the trade takes place after the market closes. This means you may pay more or less for the mutual fund than the exact time you placed your order.
However, an exchange-traded fund often comes with a commission to buy and sell it. Some fund companies will waive this fee if you are purchasing their own ETFs. Otherwise, you want to purchase ETFs through low-cost online brokerages.
Frequent trading of an ETF is not recommended. The commission paid can quickly add up. A lump sum purchase may be the best bet with an ETF.
ETFs do offer a lot of tax efficiency. Portfolio turnover is low with an exchange-traded fund. Portfolio turnover is when the fund buys and sells the underlying investments such as stocks. Most ETFs track an index which requires very little buying and selling so less capital gains are created. Capital gains are the profits from selling an investment. Capital gains are subject to tax so less capital gains mean less taxes to be paid.
Another nice feature of ETFs is their transparency. ETFs list their holdings online daily. Therefore, you can know each day in what you are investing. This doesn't occur with mutual funds. An ETF's prospectus or the company's website will list the holdings for an investor to see.
Be aware many new ETFs being offered are tracking newly created indexes. These indexes have been created by the fund companies who are selling the ETF. It is questionable whether these new indexes will be as beneficial as the traditional indexes. So you may want to stick to an ETF that tracks a traditional index.
Also, some new exchange-traded funds are actively managed funds. These can charge very high fees that are counter to the original idea behind ETFs. Again, it is wise to give these ETFs a pass.
Many options are available with ETFs. You have available ETFs to track stocks or bonds. You can invest in commodities through an exchange-traded fund. You can invest in a specific sector of stocks.
So ETFs are like the middle child. You get a product that offers diversification like a mutual fund but trades like a stock. ETFs offer a low-cost and tax efficient way to invest. Do a little research and you may find one or a couple in which you really want to invest.
May I recommend my ebook, Investing $10K in 2013
Content copyright © 2014 by Sandra Baublitz. All rights reserved.
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