Exchange traded funds are relatively new to the investing world. The first ETF was available in the mid 1990’s. They have become more popular, since they offer investors some unique advantages. What exactly is an Exchange Traded Fund? Do ETF’s deserve consideration in your portfolio?
ETF’s are like many other equity securities. They are very similar to mutual funds in that they invest in a specific group of stocks. Most of them track specific index funds, such as the S&P 500. The big difference is that the ETF trades just like a stock on an exchange. Mutual funds are shares that you redeem through a fund company. Because of the way they trade, ETF’s are priced throughout the day. Mutual funds use forward pricing, which occurs at the end of the business day.
Exchange Traded Funds – Similar But Different
Expenses on ETF’s tend to be lower that those on mutual funds. The intention for exchange traded funds is to be low-cost and simple to manage. Since most ETF’s track a specific index, they do not require high volumes of trading. Another benefit of the ETF is tax efficiency. Unlike some mutual funds, ETF’s rarely make capital gains distributions. This can provide some tax benefits to the investor.
It’s important to understand the differences between mutual funds and exchange traded funds. Depending on your investment goals and strategies, both may have an appropriate place in your portfolio. Like any other investment product, there are always advantages and disadvantages to consider.
Exchange Traded Funds – Advantages
Pricing and Ease of Trading – Since ETF’s are available on stock exchanges, they can be bought and sold at anytime during business hours. ETF’s can be purchased at the exact price they are currently trading for. Mutual funds use forward pricing, which means they are priced at the end of the business day. So, if you enter an order to buy a mutual fund at 10:00 am in the morning, you won’t know the actual price until the end of business.
The other advantage with ETF’s is that you only need to afford the price of one share to gain access. With some index funds or mutual funds, you may have a minimum deposit to start investing. With an ETF, you could buy one share and start investing in the fund.
Diversity – Like mutual funds, ETF’s also provide a great deal of diversity. The underlying assets in the fund are usually made up of a large pool of investments. This helps manage risk and gives the investor a wide variety of securities to choose from.
Low Operating Costs – Fees are one the things that end up costing investors precious dollars in their portfolios. Since the ETF is specifically designed to be low cost, it provides efficiency. The lower the expenses, the better it is for you.
Tax Efficiency – ETF’s are popular in taxable investment accounts due to their efficiency. As mentioned, most ETF’s do not distribute capital gains to the investors. Because of that, there are no tax consequences until the shares are sold. This makes them very attractive for people looking to build tax efficiency into their portfolio. This is often a huge selling point for people considering exchange traded funds.
Exchange Traded Funds – Disadvantages
Commissions and Over-trading – One of the disadvantages with ETF’s is for people who trade in and out of shares frequently. If you get hit with commissions every time you make a trade, you need to make sure you are profiting. Unfortunately, many people do not. I think investors should take a long-term view with any investment. There is a great deal of research to show the benefits of a buy and hold strategy. I know a lot of people who have attempted to market time with ETF’s and ultimately gave up.
Market Influence on Price – ETF’s are subject to the same supply and demand forces that dictate the stock market. Even if the underlying assets within the ETF are more valuable, the market may not support that. While most ETF’s are very close to price per share as a comparable mutual fund, it is important to understand the impact of the market forces.
Exchange Traded Funds – Another Handy Tool for Investors
Exchange traded funds provide another level of diversity and flexibility for investors. They can give you access to a wide variety of investment options. They have low fees and simple management. The key is to find ETF’s that match your investment goals, time horizon, and risk tolerance.
Remember, all investments have pros and cons that you need to consider. An ETF might be a great investment for some people, but others might be better off with index funds or mutual funds. Many people now have a combination in their portfolios. As mentioned, ETF’s provide tax advantages that should be considered. If you have a solid strategy, exchange traded funds can be a fine addition to any portfolio.