A Beginner’s Guide to ETF Investing
What Are ETFs — and Should You Invest in Them?
You’ve probably heard the term “ETF” whether from your advisor or when reading investing news or blogs. But when I talk to people about their portfolios, sometimes they have questions about the intricacies of ETFs and the benefits and drawbacks compared to other investment vehicles. So today, I wanted to take some time to cover the basics of ETF investing and some questions to ask yourself to determine whether or not ETFs are right for your portfolio.
What is an ETF?
ETF stands for exchange traded fund. An ETF is a pool of money (a fund) used to buy stocks, bonds or other investments. That pool is then divided into shares which are traded on an exchange. When you as an individual investor buy a share, you buy a portion of the fund from someone else on an exchange at an agreed price. When you sell it, it is to another buyer.
ETFs have exploded in popularity over the past decade or so. For example, there were only around 200 ETFs on the market in 2005. Today, there are more than 5,000 ETFs on the market, and ETFs hold almost $3 trillion in investment assets, according to the Investment Company Institute (ICI).
Comparing ETFs and Mutual Funds
Exchange traded funds are similar, but not identical, to mutual funds. There are some important differences between ETFs and mutual funds you should be aware of as you consider whether purchasing ETFs is a wise strategy for you.
First, the similarities. Both ETFs and mutual funds pool investors’ money to purchase stocks, bonds and other types of securities. And both types of funds are run by professional portfolio managers who buy and sell securities with the goal of achieving the fund’s stated objectives.
Unlike mutual funds, however, ETFs are listed on major stock exchanges. This means you must have a brokerage account in order to buy and sell ETF shares. Conversely, mutual fund shares are traded directly with the fund company, so a brokerage account isn’t necessary in order to trade securities.
Differences in Trading and Pricing
ETFs and mutual funds are also different in the way they’re traded and priced. When you purchase shares of an ETF, you’re buying them directly from someone else on the exchange at an agreed-upon price. Similarly, when you sell ETF shares, you’re selling them directly to someone else. ETFs are actively traded throughout the day, so their share prices fluctuate minute by minute, just like common stocks.
With mutual funds, you buy shares from and sell shares to the fund itself at the fund’s net asset value (NAV). A mutual fund’s NAV is published at the close of trading each day, so mutual fund prices don’t fluctuate throughout the day like ETF prices do.
When demand is sufficient, blocks of new ETF shares are created by an investment bank, which can also dissolve ETF shares by selling securities and unwinding blocks of shares. This helps ensure that ETF shares remain fairly priced while also avoiding trading costs associated with new cash additions or withdrawals from the fund.
Active vs. Passive Management
Another big difference between ETFs and mutual funds has to do with active vs. passive management. The vast majority of ETFs are passively managed index funds, which means they are managed to track an investing index, such as the S&P 500 or the Wilshire 5000. However, most mutual funds are actively managed, though there are a number of passively managed mutual funds available.
Passive vs. active investing is a big topic, but here’s our take in a nutshell. For many years we’ve watched thousands of individuals invest, and the vast majority who tried to make money by picking hot stocks or by market timing end up hurting themselves more than they helped themselves. Sometimes badly. So, we generally believe individual investors are better served by a primarily passive approach.
While many people believe that active investing is far more exciting – especially with its imagined potential for “beating the market” – the main problem with active management and stock picking is an astounding lack of success. While the financial industry spends millions of dollars promoting active products that promise to outperform the market, even professional active managers rarely beat their benchmark over the long term.
To be fair, there are mutual fund managers with great track records. But past performance is not predictive of future performance. With more than 10,000 mutual fund managers out there trying to beat the market, statistics dictate some of them will perhaps outperform the benchmark. The problem is that this is an “in-sample” analysis; there is no statistical evidence that any of them will be able to repeat good performance in the future.
Due to their passive management, ETFs typically feature lower expense ratios than mutual funds. ETFs are also usually more tax-efficient than mutual funds — the low turnover of securities achieved by passive management generates lower taxable capital gains in the fund.
The fact that ETFs don’t have to raise cash to meet investors’ redemption requests by selling securities, which mutual funds sometimes must do, also reduces capital gains. You will still have to pay taxes on the dividends and on any realized capital gains when you sell, but it is unlikely you will be faced with a meaningful capital gains distribution from the fund while you hold it. So, ETFs can be very effective tools to gain exposure to certain segments of the market in a tax-efficient way.
Questions to Ask
So which type of investment — ETF or mutual fund — is the best choice for you and your investment portfolio? Here are a few questions that can help you determine the answer:
- Do you want the lowest possible investing costs? If so, an ETF or passively managed mutual fund is probably the best choice.
- Do you want to maximize tax efficiency when investing? Again, an ETF or passively managed mutual fund is the best way to achieve this. Note: Tax efficiency generally isn’t an issue if the fund will be held in a tax-advantaged retirement account such as an IRA or 401k.
- Do you prefer active or passive investment management?
- Do you want access to the widest possible selection of fund options? If so, you may opt for a mutual fund. While the selection of ETFs has grown significantly since 2005, there are still many more mutual funds on the market.
It’s Not Necessarily Either/Or
Deciding between ETFs and mutual funds doesn’t have to be an either/or proposition. There may be a place for both of these types of investments in your diversified portfolio.
A skilled financial advisor can help you choose the right EFTs and/or mutual funds based on your particular investing goals and objectives. To learn more about the wealth management services we offer at Personal Capital, click here.
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