Exchange Traded Funds (ETFs)

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Exchange Traded Funds

Exchange Traded Funds (ETFs) are quite the rage in the investment industry right now. It’s hard to visit a page on an investment-related website without seeing an article promoting “5 Hot ETFs” or “3 ETFs Ready to Soar.” But perhaps we should take a step back and answer two questions about ETFs:

  1. What are they?
  2. Why is it worthwhile for you to know about them?

ETFs: The Basics

Exchange Traded Funds can be described as index funds that trade like individual stocks. (That said, some newer ETFs work more like actively managed mutual funds than index funds.) Like index funds, ETFs can be an excellent tool for constructing a low-maintenance, low-cost, diversified portfolio.

Diversification: Broad diversification has never been easier than it is with ETFs. For example, a simple 3-ETF portfolio (VTI, VEU, and ITE) would instantly spread your investment across:

  • More than 3,000 U.S. stocks,
  • More than 2,000 stocks from over 40 other countries, and
  • A collection of U.S. Treasury bonds to help reduce overall volatility.

Low Costs: Most ETFs have very low expense ratios. As a result, they tend to outperform the majority of comparable actively managed mutual funds. (For example, a low-cost ETF that tracks a U.S. stock index is likely to outperform the majority of domestic stock mutual funds.)

Low-maintenance: When investing via actively managed mutual funds, you have to check up on your funds regularly to make sure the managers are still there and that their strategies are still working. When investing in individual stocks, you have to keep up-to-date on those companies to make sure they’re still worth owning. With ETFs, all you need to do is spend a few minutes each year (or each quarter) rebalancing your portfolio to make sure your asset allocation never gets too far out of whack.

ETFs vs. Index Funds

The fact that ETFs trade like individual stocks has several consequences, but the most significant for typical investors are that:

  1. You can get access to ETFs from any brokerage account, and
  2. You can buy ETFs in small increments.

To invest in index funds, you often need an account with the fund company in question. For example, to get access to Vanguard’s index funds, you’d need an account with Vanguard. Vanguard ETFs, however, can be purchased through an account at any brokerage firm.

Another helpful feature of ETFs is that they can be used to get around the minimum investment requirements that many index funds have. For example, Vanguard’s Total Stock Market Index Fund requires a minimum investment of $3,000. In contrast, the ETF version of that same Vanguard fund can be purchased with an investment of under $60.

Be Sure to Do Your Homework

Of course, not every ETF is low-cost. Nor are all ETFs diversified investments. Before investing in an ETF, be sure to check that its expense ratio is reasonable (less than 0.50% in most cases) and that its portfolio fits well into your desired asset allocation.

About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor, where he explains topics like Roth IRA withdrawal rules.



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1 Lakita (PFJourney)

I’ve been looking at ETFs as opposed to Mutual Funds. When I’m ready to dive into investing I’ll take a closer look, but I don’t see too much difference besides how they’re bought/sold.

2 Mike Piper

Regarding ETFs vs index funds, you’re absolutely right: There isn’t much difference aside from how they’re bought & sold.

If we’re talking about ETFs vs actively managed mutual funds (i.e., funds that try to “beat the market”), there’s a big difference. Specifically, ETFs are typically much lower cost than actively managed mutual funds.

Unrelated note: Does anybody else find it amusing that one of the adsense ads on this article is the very same “3 ETFs Set to Soar” headline that I mentioned? :)

3 Neil

ETFs vs “actively managed funds” is horrible terminology. Some ETFs are actively managed, and have the fees to prove it. The simple title of ETF is not a guarantee of low fees or passive investing.

ETF and mutual fund are comparable terms. But both active management and passive management exist in both classes.

4 Mike Piper

Point taken. I was more careful in the original article, and should have been more careful in my wording in the above comment–something to the effect of “index-tracking, low-cost ETFs vs. actively managed funds.”

5 David H.

ETFs are definitely an easy way to invest these days. I’m a customer at Schwab and they just released a few Schwab ETFs that have no commission to trade in no matter what amount invested in. More companies are starting to do this which is GREAT. Commissions are a HUGE expense for small investors like me who aren’t buying shares in the hundreds but in the single digits to dozens range and they eat away your chance at good returns.

6 Neil

I think you missed one of the big disadvantages to ETFs – in most cases you pay a transaction fee to your brokerage. (If you have a fee free account, then you’re good). Often, as with stocks, there’s a price or fee penalty for purchase odd quantities of ETFs (ie., not in multiples of 100). For most people, this makes them a poor option for investing with monthly contributions, better for investing lump sums that you’ve already saved up.

Really, the difference between ETFs and mutual funds is the purchasing method. ETFs are convenient, and can be bought or sold at any intra-day price, unlike mutual funds that settle at the day’s closing price. But they’re not as different from mutual funds as most people seem to think. For almost any ETF out there, you can find a comparable traditional fund with similar fees.

7 ETF Newsletter

This is a very good point Neil. So if you go the lump sum route, you take on more risk than dollar cost averaging. Seems like there is an opportunity here for the brokerage houses to bring the investing costs down for ETFs.

8 Funds Investing

Did you know CFDs were created in the beginning of the 90s by the derivative trading desk at Smith New Court, a trading company based in London. Funds Investing

9 Craig/FFB

I purchase ETF’s via Sharebuilder. Yes, there are commissions but they are low and I don’t need the startup money you need for many mutual funds.

10 Kris

Another advantage of ETF can be sector exposure. I bought XLU to get some exposure in utilities. There are also ETFs for commodities such as Oil and Gold.

There are also leveraged ETFs that aim to do things like X2 the Dow for the day, or the inverse. These ETFs are more for day traders though

As noted above ETFs have dual costs though. Transactions costs and the typically fee structure.

11 Kris

The typical tax advantages of ETFs over mutual funds was missed in this article also. Because ETFs don’t have to sell shares for redemption they don’t have the taxable gains at the mutual fund level, this is a big part of the expense ratio difference.

12 Mike Piper

True, many (though not all) ETFs are somewhat more tax-efficient than traditional open-end index funds. Tax differences, however, are not reflected in the expense ratio.

13 Kris

Investopedia explains Expense Ratio
Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund’s investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees.

14 Mike Piper

I can only assume that investopedia is referring to taxes incurred by the fund management company.

Capital gains distributions (and the taxes thereon) are not included in the expense ratio of a fund or ETF. That’s why reporting services (Morningstar, for example) will often separate out pre-tax returns on a fund from after-tax returns. If the taxes on capital gains distributions were included in the expense ratio, there would be no need to do this.

15 Kris

Good follow up Mike. Thanks

16 Mike Piper

Thank you for the discussion, Kris. I’m sure you’re not the only person who’s ever read that (somewhat poorly worded) investopedia definition and came away with the conclusion you did. :)

17 Kris

Another area that is relevant to this discussion about index verus active funds/ETFS, is that active investments can be influnced signiicantly by large instiutional investors like db pension plans which might redeem there investment and force the hand of mutual fund manager and make them sell investments when they don’t want to.

18 Robert Espe

One thing to be aware of, the fact that ETF’s CAN be traded like stocks (at any time of the day) for some people is a temptation to try and time the market with them. This undermines the whole point of index funds, and pretty much negates any cost savings as well.

19 innocriss

ETFs are definitely an easy way to invest nowadays. Commissions are a HUGE expense for small investors like me who aren’t buying shares in the hundreds but in the single digits to dozens range and they eat away your chance at good returns.

20 Victorino

eTraded Funds promise great investment and income opportunities. I’m still studying different investment schemes (mutual funds, ETFs, etc) to discover what will become more advantageous to me. Good thing there are nice finance bloggers who will always there to guide people like me who are still new in this financial world.

21 Jose@Christian Business

I first encountered “ETF” few weeks ago and I’m glad to see the basics here.

When I start investing this piece of information would be useful for me.

Thanks.

Jose

22 The Rat

This is an awesome thread as it provides great background basics on ETFs. Currently, I don’t own any ETFs in my portfolio, but I am thinking about getting into index funds to further diversify over a broad range of stocks while enjoying lower costs in comparison to mutual funds.

I think ETFs can be easier to purchase as you can buy many of them yourself just like stocks through an online discount brokerage account.

Nice post.

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