Exchange-traded funds are collections of securities that trade like stocks. They are different from normal stocks in that instead of you owning one company, you own a block of shares whose objective is to track the performance of an index like the S&P 500 or the Dow Jones Industrial Average.
The price of the ETF varies based on the performance of the holdings within it. If the ETF tracks an index with two dozen companies that are all going up, then the price of the ETF will typically also go up.
What You Should Know About ETFs
In understanding an ETF, there are several things you need to know about. We’ll start with the advantages that an ETF has over other types of investments that people might use. ETFs are most like mutual funds and can be used as a comparison. Let’s look at ways in which mutual funds are commonly criticized and see how ETFs compare.
When reading the complaints about mutual funds, I want you to keep in mind the fact that they are still important. Their value comes from the sheer number of assets held within them as well as the fact that they are used by many retirement plans. I just want to compare them in order to make the discussion as clear as possible.
Mutual funds can be costly – Since ETFs track indexes, they typically have lower fees attached. One of the reasons, among many, for this is that ETFs don’t have managers and analysts picking the securities like mutual funds do. They also have lower transaction costs.
ETF sponsors also do not sell shares directly to the public like you would see with mutual funds. Instead, large blocks of shares called creation units are exchanged. The predictability of these units is the reason there are fewer transactions.
When dealing with mutual funds, you never know who is going to buy and sell shares each day. The difference between ETFs and mutual funds also leads to certain tax advantages, like lower rates of capital gains distributions being sent to the investors.
The price of a mutual fund is only figured after the market closes. If you buy in the morning, you will pay whatever the price is at the end of the day.
Think about what might happen to the markets because of a terrorist attack. The owner of an ETF could sell in the morning, but a mutual fund owner would not be able to sell until the end of the day. This advantage is known as liquidity.
Some take it as a disadvantage because they think it may encourage a higher volume of trading when funds are meant to be held for the long term, but I see it as a critique of how impulsive some investors can be. By working with the right advisor, you can avoid succumbing to emotion and trading your holdings.
Mutual funds are actively managed – ETFs try to mimic an index instead of outdo it. Some see this as an advantage and others as a disadvantage. It all depends on whether or not active management is worth the added expense.
Some managers are well known for beating others, but if we knew who was going to outperform who, no one would bother reading articles on ETFs. In my experience the lack of active management can be an advantage because you get the equity exposure at typically a lower cost.
What Are the Other Reasons to Consider ETFs?
With ETFs, you gain exposure to specific sectors of the market. You may choose to do this either because you are familiar with that sector or because you want to speculate on something that may cause that sector to do better than others.
Remember, however, that putting too much into a sector could disturb asset allocation. ETFs have grown in popularity since they’ve been introduced. What started as offerings that tracked things like the Dow Jones or Wilshire 5000 has evolved into something with offerings in a wide range of sectors like alternative energy, currency, and IPOs.
It feels like there are too many, but investors like the variety of offerings because it allows them to build a diverse portfolio.
It seemed like, at first, ETFs were a substitute for mutual funds and that they would take capital away from them. This has happened, but not to the extent that many thought it would happen.
This could be due to marketing. Many ETFs are based on speculative indexes, meaning that only people with a high tolerance for risk invest in them. In many cases, these are people who enjoy picking stocks. I don’t think many of these investors focus on the costs of their long-term holdings, as they would have embraced ETFs if they did.
Finally, advisors who get paid on commission tend not to make as much money selling ETFs for the long term as they would with mutual funds. Because many investors learn about products through their advisors, this might be why information doesn’t get passed along as quickly as it should.
Those who seek new investment products are usually investors who focus on making money in the short-term.
What I’m saying is that we lack a way for everyday investors to learn about how to invest in ETFs, and it’s why I do what I do here. I want to help you make the kinds of choices that will help you pursue your goals and build your investment portfolio.
If you have any questions about ETFs, mutual funds, or any other type of investment vehicle, feel free to get in touch with me and let me know how I can help you today.