With the economy going through questionable times, everyone is searching for the best place to save and invest. When the market gets volatile, investors want to research their options. I am opposed to jumping ship too soon, but I still encourage educated decisions.
Clients have been asking for more information on exchange-traded funds. Exchange-traded funds (or ETFs) are still relatively new investment products. They were first introduced in 1993, but have been gaining in popularity ever since.
What is an ETF?
The best way to describe an ETF is a mutual fund that trades on the stock market. An ETF owns many different stocks and attempts to mirror an index, such as the S&P 500. There are many different companies and indexes available, so owning ETFs will not impact your ability to properly diversify. There are also ETFs available for fixed income classes, or bonds.
There are several pros to owning ETFs in your portfolio. Many investors like the greater flexibility, management transparency, and added diversification that can be achieved with ETFs.
Flexibility
Since ETFs trade on the exchanges like stocks, you can buy and sell them at the fund’s current trading price. In contrast, mutual fund prices are determined once per day, at the end of the trading day. You cannot know your purchase or sales price prior to the close of business.
Transparency
These funds are also more transparent than traditional mutual funds. When you buy a specific asset class, you get what you expect. Many mutual funds tend to stray over time as managers scramble to produce better returns for the investors. When managers stray, it puts investors at risk and takes them away from their original goals.
Diversification
In choosing to further diversify your portfolio, you may decide to increase your exposure to a particular industry or sector. Rather than trying to pick the one stock that may prove profitable, purchasing an ETF that focuses on that industry can give you that exposure while reducing the risk. Owning multiple stocks with one purchase is a cost-effective way to accomplish this goal.
Cost savings
From a financial standpoint, investing in ETFs can also result in reduced taxes and lower costs.
ETFs offer reduced tax liabilities when it comes to taxable gains. When mutual funds sell stocks for a profit, the shareholders are financially liable for their portion, regardless of whether the investor personally sold any mutual fund shares. ETFs don’t buy or sell stocks. The low turnover means that there are no gains to pass along to investors.
The best advantage of ETFs over mutual funds is the lower annual operating expense. Most mutual funds have different annual fees. These fees can bring annual expenses into the 3-4% range and severely impact your ability to see the growth in your investment. In contrast, many ETFs have annual operating expenses of less than 0.5%.
ETFs are not for everyone. The biggest hurdle is commissions. Since ETFs trade like stocks, there is a commission involved in the purchase. This is not a problem when investing a large sum of money, but it can be a challenge if you want to set up a monthly purchase plan to take advantage of dollar cost averaging.
Before choosing to purchase an ETF, please review the pros and cons to determine if this investment vehicle works for your goal. Consult your advisor and compare ETFs to your current holdings so that you are able to make a truly informed decision.
Ozeme J. Bonnette is a financial coach, speaker, and author. She began her career at Merrill Lynch, and now works to increase financial literacy. She teaches and speaks to groups and organizations throughout the U.S. She earned 3 Bachelor’s degrees at Fresno State and an MBA at UCLA’s Anderson School. She blogs at http://www.povertynorriches.com. Send questions and comments to ozeme@thechristianmoneycoach.com.
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