ETFs are currently one of the most popular ways to invest. Many of my clients have heard they should consider moving their money into an ETF. However many of them are sheepish to admit they aren’t totally clear on what an ETF is. Let’s breakdown what’s an ETF and what are the top 5 benefits of ETFs.
What’s an ETF?
The acronym ETF stands for Exchange-Traded Fund. An ETF is a fund that holds certain assets and divides this ownership into shares. The assets can be shares of stock, bonds, gold, foreign currency etc. They vary depending on the type of ETF. The most common ETF’s follow an index like the S&P 500. The very popular Vanguard S&P 500 ETF (VOO) invests in the 500 companies of the S&P 500 with a goal of matching the return of the S&P 500.
Isn’t this just like a mutual fund?
Like ETF’s mutual funds hold a pool of assets and you purchase shares of the fund. Mutual funds can also aim to match an index fund, similar to the ETF that aims to match the S&P 500. The biggest difference between a mutual fund and an ETF are that ETFs trade like stocks. You can trade ETFs throughout the day when the markets are open. Mutual funds are purchased directly from the mutual fund company and the price is calculated only once a day after the market closes. Mutual funds are also typically more expensive to own, which is currently a major reason so many investors are moving their money to ETFs.
What are the benefits of ETFs?
- Cost – ETFs typically cost 1/3 less than mutual funds. They have no loads or hidden fees. Many brokers offer commission-free ETFs to customers.
- Diversification – An ETF allows you to invest in specific indexes, sectors, countries or styles without needing to become an expert in each of these topics. For instance you can purchase an international ETF if you would like to invest in companies all over the world without having to research each company in every country.
- Ease of Buying and Selling – ETFs are traded like stocks. You can buy and sell them throughout the day when the markets are open. Mutual funds are owned by the funds and are only priced once a day. If you have ever wanted to sell one of your mutual funds you may have noticed you have to wait until the end of the day for the transaction to go through. That wait doesn’t happen with ETFs.
- Tax Advantages – Mutual funds must pay out their capital gains (the gains for selling a stock at a profit) at the end of each year. So as an investor who owns shares in a mutual fund you may have to pay capital gains tax even though you did not sell your shares. ETF owners only pay capital gains tax when they sell their shares.
- Transparency – Mutual funds must disclose their holdings only quarterly. This means you can only see what the fund is buying and selling every 3 months. By contrast the majority of ETFs publish their holdings everyday. This matters because you want to see that the mutual fund is not varying from their stated purpose. For instance if you bought a mutual fund focused on large, US based companies you want to make sure they are not investing in international companies – which are much riskier. This variation from the original fund purpose is called “style drift”.
Unfortunately no investment is immune from risk. However ETFs do have benefits you should consider when building out your portfolio.
Want a review of your portfolio to understand the costs and risk level of your investments? Learn more about my Quick Start project-based financial planning.
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