If you’re not an experienced investor you may not have heard about ETFs, which are an increasingly common way to invest at a low cost. We’ll take a close look at ETFs to determine if they are right for you when it comes to saving for your future, including its advantages and pitfalls.
Why should we care about ETFs? Formally known as exchange traded funds, ETFs have grown to be a sizable portion of the investment market with $2.5 trillion in US assets at the end of last year. While the domestic mutual fund market at over $16 trillion still dwarfs ETFs, they continue to increase market share every year.
In its simplest form, ETFs are funds that invest in a large number of individual stocks similar to a mutual fund. The longest lived ETF is SPY and holds the 500 stocks in the S&P 500. By putting your money into this one ETF, you achieve the diversification of investing in hundreds of stocks. ETFs are not just limited to this one asset category. You can find ETFs that hold stocks in US small companies, international developed and emerging markets, real estate, precious metals and commodities.
How are ETFs different than mutual funds? There are many technical differences between these two investment options, but we’ll focus on those most important to most investors.
First, unlike mutual funds, ETFs trade throughout the day with a price that varies generally along with the value of the investments that the ETF holds. In contrast, mutual funds only trade at the market close. If you see the market dip in the middle of the day and want to take advantage of the price, you’ll have to purchase an ETF.
Second, ETFs can be held in almost any brokerage account at a low cost, including those with traditional brokers such as Merrill Lynch and discount ones like Charles Schwab. While most mutual funds do have wide availability as well, ETFs from different companies can be held in a single account with low costs. For example, you can open an account at Schwab and invest in SPY for $5 a trade (with no cost for Schwab branded ETFs). If I want to put money into a Vanguard mutual fund held at Schwab, then for most investors it’s $76 to buy to fund, with the sale performed at no cost.
Sure if you open account at Schwab, you can invest in a Schwab mutual fund or ETF essentially for free. With Vanguard it’s the same for its ETFs and mutual funds. But by investing in ETFs, with one investment account you can rebalance funds at a lower cost if you prefer to use multiple investment companies.
Third, ETFs in most cases have low annual expenses and are tax-efficient (if held in taxable investment accounts). For example, SPY has an annual expense of 0.1 percent, and while index mutual fund costs can be even lower most are not. Also ETF investors may pay less in capital gains tax over time as they are less affected when other investors sell to generate cash.
Fourth, even though ETFs own a basket of stocks like a mutual fund, they may trade at a discount to the underlying value of the stocks or at a premium. Plus like any stock, ETFs have a slight price difference between the “bid” and the “ask,” which introduces unseen transaction costs. It should be said that with the most popular ETFs these costs do not come into play to any significant degree. In contrast, mutual funds always trade at the value of its underlying securities.
Finally while most ETF money is invested in low cost, passively managed investments, there are the exceptions that use complicated strategies that can involve significant expenses and deviations from expected performance. One example is so-called “triple short” funds that bet against an index by engineering an ETF that will increase three times as much as an index goes down. So if the S&P 500 declines 2 percent in a day, the triple short ETF should appreciate by 6 percent. In my experience, the price movements of these complex ETFs are unpredictable and should be avoided by most investors.
Are ETFs right for you? The most common ETFs are passively managed, low cost investments that are a good choice for most investors. But in truth, their advantages over similar cheap mutual funds are few. Rather ETFs offer a superior solution for a few particular situations. If you want to trade a diversified investment in the middle of a market day, ETFs are the answer. Also ETFs offer some investments not available through mutual funds, such as in gold bullion or a diversified basket of bonds that mature in the same year, such as iBonds. But I believe in most cases individual investors will find low cost mutual funds to be a simpler way to invest with most of the benefits of an ETF.