Guide to Exchange Traded Funds

What are ETFs and Are They Right For Me?

Guide to Exchange Traded Funds
February 25, 2014

In the world of finance, Exchange Traded Funds are relative newcomers, but they have already made their mark. Launched in 1993 by State Street Global Advisors, ETFs are now the most popular of the exchange-traded products due in part to their ease of use and modest fee scale.

What are Exchange Traded Funds?

Exchange Traded Funds are investment funds that can be traded as shares on the stock market. ETFs typically track an index (stock or bond) or commodity (petroleum, agricultural products, etc.) and hold a basket of underlying assets that track or replicate the performance of that index or commodity. During the trading day, the Exchange Traded Funds go through price shifts as they are bought and sold like stocks.

Are ETFs Right for Me?

  • Stock-Like Features - For simplicity‚Äôs sake, think of ETFs as being mutual funds that trade like stocks. This feature is important because mutual funds can only sell after the trading day closes. ETFs, however, can be bought or sold any time during the trading day. For example, an investor might choose to buy and sell an ETF within the same trading day if he realized that ETF was linked to a steeply rising S&P 500. The stock-like nature of ETFs also permits investors to engage in speculative trading strategies such as buying on margin or short selling. These strategies cannot be employed with mutual fund shares.

  • Low Costs - In areas of finance, low cost is always a good reason to take a second look at a product. In the case of ETFs, it's just one more good reason. ETFs have broad diversification and low turnover like index funds, plus they are much more cost-efficient than mutual funds. Many "actively managed" mutual funds charge 100 (or more) basis points. In the low-cost index funds, basis points can still run in the 20s and 30s. The basis point ratio for the SPDR 500 ETF is only 9.5!

    However, the cost of commission fees can't be overlooked. Each trade of an ETF goes through a brokerage firm and therefore incurs a commission fee. To guarantee you don't spend more in commissions than you gain from the low-expense ratio, you should find a low-cost broker, preferably one with single trades of $10 or less. Also, don't make many small investments; plan to invest $1,000 at a time or more to maximize the cost of the fees verses the return.

  • Broad Diversification - Exchange Traded Funds provide investors with welcome diversity. There are hundreds of ETF products available representing all the major indices and sectors of the market (large cap, small cap, fixed income, etc.). There are also many national and international choices. With so many types of ETFs available, investors are able to easily build a diversified portfolio that achieves any asset allocation model desired.

  • Tax Efficiency - Well-informed investors know that ETFs provide greater tax efficiency than mutual funds. This is due to in part to structural differences between the two instruments, and in part because mutual funds incur more capital gains taxes than ETFs due to higher frequency of trading. Additionally, capital gains incurred by the ETF is taxable only upon the sale of the ETF, while mutual funds pass on capital gains taxes to their investors during the life of the investment.

Not surprisingly, the lower taxes and costs associated with ETFs, combined with their stock-like flexibility and broad diversity, have attracted some 3.5 million Americans to invest in Exchange Traded Funds. Ask a MoneyTips financial advisor if they may be right for you.

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