What Is An ETF and Are ETFs A Good Investment?

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What Are ETFs
Photo Credit: TeroVesalainen

An exchange-trade fund or ETF is a basket of securities that tracks a particular index, bonds, commodity, or asset class. First created in 1993, ETFs have grown to over 2,100 funds available today just in the U.S., and over 6,000 funds worldwide containing over $4.5 trillion in assets.

There are ETFs available for almost everything. There are market ETFs that track particular indexes such as the S&P 500, NASDAQ, or Dow Jones. Sector specific ETFs are available that allow investors to target specific industries such as energy, biotech, or telecommunications. Commodity ETFs allow investments in gold, oil, soybeans, corn, and more. There are even actively managed ETFs that are designed to outperform an index.

ETFs are traded just like stocks during the day when the stock exchanges are open. Similar to individual company stocks, an ETF has a ticker symbol and prices are updated throughout the day. ETFs are bought and sold through a brokerage account and are typically charged the same commission by the brokerage as regular stocks.

Unlike investing in a single company’s stock, which could go bankrupt and leave you with nothing, when you purchase a ETF you are diversifying your investment into a group of equities and spreading out your risk. A particular stock in the group could go up or down by a lot, but the overall performance of the ETF will be evened out by all the other securities in the basket.

As you are probably noticing by now, owning an ETF is a lot like owning an index mutual fund, only with more flexibility. Investors get the diversification and low costs of an index fund, along with the benefit of being able to trade them like stocks.

How Do You Buy ETFs

As mentioned previously, ETFs are traded on an exchange and you can buy them almost anywhere you can buy a stock.

Your best bet is to buy them through a low cost online brokerage. The commissions can vary depending on the broker, but generally range from free with Robinhood, Ally Invest, Fidelity, TD Ameritrade, and E*Trade, to $6.95 with Merrill Edge, and as much as $20 at a firm such as T. Rowe Price.

Before you sign up to any brokerage firm, you should look on their website to see which ETF funds are available to you. Some smaller outfits may only offer certain ETFs from only the largest providers. Other brokerages may have commission-free ETFs trading programs available for certain providers if you are looking to save trading costs.

What are ETF Fees and Expenses

Compared to mutual funds, ETFs do not have load fees. Very few ETFs charge 12b-1 fees, which is an annual marketing and record-keeping fee.

To cover an exchange-traded fund’s annual operating expenses, shareholders are charged an expense ratio. Since most ETFs are passively managed, they tend to have lower expense ratios than mutual funds.

According to Morningstar, the average ETF expense ratio in 2016 was 0.23% compared to 1.45% for actively managed mutual funds. This means the average ETF will cost you $2.3 for every $1,000 you invest versus $14.50 for a mutual fund.

Expense ratios matter because it reduces your net return on investment from a fund.

Lets say you invested $10,000 over 30 years in two funds that both had a return of 10% before expenses.

The fund with an expense ratio of 0.23% will have a net annual return of 9.77% and will grow to $163,874 after 30 years.

The other fund with an expense ratio of 1.45% will have a net annual return of 8.55% and will end up with only $117,191 after 30 years.

That 1.22% may not seem like much, but over 30 years it is almost an extra $47,000 that could be in your pocket.

Tax Advantages of ETFs

ETFs are extremely more tax-efficient than mutual funds due to how they are created.

When investors want to redeem their shares in a mutual fund, the fund must sell shares of stock to free up cash. If appreciated stock is sold, it creates capital gains, which are distributed to shareholders at the end of the year. These capital gains could be both long-term if the assets were held more than a year or short-term.

In 2018, long-term capital gains tax rates are either 0%, 15%, or 20%. Short-term rates correspond to your ordinary income tax bracket, which ranges from 10% to as high as 37%.

When an ETF shareholder wishes to redeem their shares, the ETF doesn’t sell any stocks in its portfolio. Instead, it performs what is called an “in-kind redemption”. Therefore an ETF investor only pays capital gains taxes when they finally sell their shares or when an ETF trades to change the holdings in its basket. An astute investor who has held their ETFs for over a year would be eligible for the lower long-term capital gains tax rates.

To take advantage of ETF’s tax efficiency you can hold mutual funds in a tax advantaged retirement account and ETFs in your taxable accounts.

When To Buy an ETF

Lets say you want to invest in a S&P 500 index mutual fund. To get the absolute lowest expense ratio possible, some funds require you to initially buy in with minimum investments that are as high as $10,000 for their premium classes. If you do not have the money available to make such a large investment, you can buy a comparable ETF index fund for much less. With an ETF, you can buy as little as one share.

For example, the investor shares of the Vanguard 500 Index Fund (VFINX) has an expense ratio of 0.14% with a $3,000 minimum. With $10,000 available, you can purchase the VFIAX admiral shares instead with an expense ratio of 0.04%. Or you can just purchase shares of the Vanguard S&P 500 ETF (VOO) with the same expense ratio as VFIAX for $258 a share plus whatever your broker charges for trading commissions.

Having a low initial investment lets a beginning investor build a well-diversified ETF portfolio easily.

On the other hand, if you want to invest a little bit from your paycheck each month, a mutual fund might be a better choice. By sticking with no transaction fee, no load mutual funds, you can avoid paying brokerage commissions for each trade.

Someone with $10,000 to invest in an ETF who pays $7 per trade, the trading cost is only 0.07% of their investment capital. Meanwhile, someone who only has $100 available to invest, the $7 commission takes a 7% bite out of their investment funds.

You will always come out ahead investing in an ETF than a load mutual fund. This is especially the case if you have a large lump sum to invest. A mutual fund with a 5% front-end load means you’ll pay $500 for the sales charge when investing $10,000. You should never buy a load mutual fund if you can help it.

Disadvantages of ETFs

The disadvantages of ETFs compared to mutual funds include trading costs, a longer settlement period, and illiquidity.

If you want to invest small amounts at regular intervals, a mutual fund may be a better choice due to trading commissions.

Since ETFs trade like stocks, they also have a settlement date that is two business days after the trade is completed before the cash is available. Mutual funds settle the next day. Of course, you can get around this problem by having a margin account.

Last of all, some of the lower volume ETFs may have a large spread between the bid and ask prices. This means you will be buying at the higher ask price and selling at the lower bid price if you want to get out of a trade quickly.

Closing $ense

Exchange-traded funds have become very popular since they’ve become available. They are attractive to many investors because of their low costs, diversification, tax efficiency, and ability to be traded just like stocks.

ETFs have no front-end or back-end sales load like mutual funds. The expense ratios of passively managed ETFs can be as low or lower than comparable index mutual funds without the high initial investments needed to get into the fund.

ETFs may not be as cheap as owning individual stocks, but you get the benefit of diversification from owning a bunch of stocks in an ETF and reducing your overall risk.

With ETFs, you can control when you pay capital gains tax. This makes them a good choice to purchase via taxable accounts. ETFs also throw off dividends just like normal stocks and mutual funds. These dividends are frequently qualified dividends, which are taxed at long-term capital gains rates.

Because ETFs trade like stocks, you can purchase them any time during the day the market is open. Mutual funds’ price or net asset value (NAV) update once a day at the end of the day and you can only buy or sell mutual funds once the market closes. An ETF’s NAV updates multiple times a minute. You also have multiple trading options available such as limit orders, stop-losses, buying on margin, or selling short.

Do you own any ETFs? What is your preferred brokerage or fund company?

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