ETFs are sweeping the investment universe these days! If you’ve been staying with mutual funds and avoiding ETFs you need to take a serious look at them. For many, many investors, ETFs will be the better investment vehicle.
What is an ETF?
An ETF, or Exchange Traded Fund, is generally an index-, market- or commodity-based investment vehicle in which both the composition of the fund and its performance are closely correlated to the underlying index, market or asset. It can be based, for example, on a given stock market index, sector or industry group, or a commodity such as oil or gold. In fact in today’s diverse investment environment, there’s an ETF for nearly every stock sector, commodity or individual market exchange, including foreign exchanges.
ETFs have minimal management, usually known as passive management. The purpose of the funds is not to outperform the market it tracks, but rather to closely match it’s performance. ETFs are meant to be pure plays on a given market, sector or commodity so management of the funds is generally limited to maintaining the necessary fund composition to match the underlying market. While this might seem like a disadvantage when compared to professionally managed mutual funds, the fact is that most mutual funds fail to outperform the indices in their respective markets and sectors, and many even under-perform them.
Why convert to ETFs?
ETFs have several advantages over mutual funds, and they’re significant.
Real time trading and liquidation.
When you trade mutual funds—whether you’re buying or selling—the price you get is the price at the end of the day. On an ordinary day, this limitation doesn’t have much effect on your investment performances. But on those days where stocks and other investments are either rising or falling rapidly it can make a substantial difference. If, for example, you make a decision to buy stocks early in the day, but the market rises 5% during the course of the day, you will pay the higher price at the close, not the lower price from earlier in the day. The same will be true on a day when the markets close down by similar percentages. With ETFs you get the price at the time the order is executed, regardless of when it happens. This gives you more control over the trading process and the prices at which you expect to buy and sell.
Hands off management.
Professional management is a big reason in favor of mutual funds, but it can also present two major problems. First, as stated above, very few funds out-perform their underlying markets, and second, whether you out-perform, match or under-perform the market, you’re paying for that management. ETFs are essentially a play on the sector, market or commodity, so you’re at least guaranteed to match the market—and that’s better than many professionally managed mutual funds do, only you aren’t paying extra for it.
This is actually closely tied to the professional management issue. In the effort to beat the market, mutual fund managers buy and sell stocks creating capital gain distributions that give rise to potential income tax liabilities. This happens even though you, as owner of mutual fund shares, never sold any of your investment in the fund. Since ETFs are index funds, management generally doesn’t buy or sell securities in nearly the same frequency as mutual funds do. This gives you greater control over the tax liabilities you incur as a result of owning the fund.
Several factors are at play here. Once again, since mutual funds have active management, there are more fees than there are with ETFs. Passive management just costs less. And perhaps just as important as active management is the fact that mutual funds are engaged in the business maintaining customer accounts with all the expenses that adds to the mix. Also, ETFs lack 12(b)-1 fees common to mutual funds, as well as redemption fees on the back end. Taken together, the fact that such fees are either lower or non-existent with ETFs can increase your rate of return, especially over the long term. One caveat on fees however—if you gradually increase your various positions by, say, dollar cost averaging out of payroll deductions or some other form of regular contribution, ETFs may not be the best choice. ETFs involve broker commissions (though some firms waive these) so you will pay more in commissions than if you were to do the same with mutual funds. Since you’re investing directly in the mutual fund, you generally will not have to pay a fee each time you add to your holdings. With ETFs not only will you pay a brokerage fee each time you buy or sell, but you’ll also pay a spread, which is the difference between the bid and ask price similar to individual stocks. These may not amount to much on any individual trade, but it can be substantial if you trade in small blocks many times over the course of a year.
When are you better off with ETFs?
ETFs aren’t for everybody, but they will work better than mutual funds for many investors. Consider ETFs in any of the following circumstances:
- You’ve discovered—as many investors have—that most mutual funds you’ve been in either don’t out-perform the market or have under-performed it.
- You’re a true long term investor, taking various positions and staying with them for years at a time. This is especially true for the very long-term horizons that retirement investing involves.
- You tend to buy large positions, rather than gradually accumulating them.
- You prefer greater control over your annual income tax liability.
Love ‘em or hate ‘em, ETFs have been coming on strong and attracting millions of investors in recent years. Never assume they are absolutely the best place for your money no matter how many people invest in them, but if you find on analysis that they’ll likely work better for you than mutual funds then it’s probably time to start making the switch.
Photo by Ian Lamont via Flickr