Last week I took a mutual fund class to finish up my CFP® Continuing Education requirement. While reading over the materials, I realized that I’ve never talked about ETFs on my blog. Because of their growing popularity, my guess is that you’ve heard of ETFs, even if you don’t understand how they actually work. Here’s what you need to know:
What is an ETF?
ETF stands for Exchange Traded Fund. Simply put, ETFs are index mutual funds that can be traded like a stock. The first ETF – the SPDR or Spider – was traded in 1993. It’s an index fund that mimics the S&P 500.
Similar to index funds, ETFs track a variety of indexes. And as with most investments, ETFs have their positives and negatives.
Benefits of an ETF
Similar to index mutual funds, ETFs offer many benefits over actively traded funds:
- They have low expenses because they aren’t actively managed. Thus, you get to keep more of your money in your account and boost your earnings.
- Studies have shown the majority of index funds beat actively managed funds over the long-term.
- They have very low turnover thus avoiding large capital gains, making them tax efficient. In addition, you can harvest tax losses to offset some of your other gains.
- They help create a diversified portfolio by giving you broad exposure to the market.
In addition to those benefits, ETFs give you access to intraday trading – meaning you can trade at the time and price that you want (or at least close to it) rather than having to wait until the close of business to find out the price of a traditional mutual fund.
Disadvantages of the ETF
The main drawback to ETFs is the commission you have to pay every time you buy or sell one. So for those of you who dollar-cost average and put in small sums every month, the commission takes a bite out of what you invest each purchase and reduces your overall return.
In addition, some ETFs that are tailored to a narrow sector – emerging markets, clean energy, nanotech – can have a higher expense ratio than a corresponding index fund.
Are ETFs right for you?
ETFs can be a great pick for some buy and hold investors who want to make a large lump some investment in a taxable account. However, most of us who make smaller investments on a regular basis are likely better off with index funds in a retirement account.