Exchange-traded funds (ETFs) have become the go-to investment for many financial advisors. According to the Financial Planning Association’s 2017 Trends in Investing Report, 88 percent of financial advisors recommend ETFs to their clients, compared to 85 percent who tout cash and equivalents, 80 percent who recommend mutual funds (non-wrap) and 61 percent who coach clients to invest in stocks.
One group of investors has been faster to jump on the ETF bandwagon than any other. Charles Schwab’s 2017 ETF Investor Survey found that 56 percent of millennials select ETFs as their investment vehicle of choice. That’s compared to 44 percent of Gen X investors and 30 percent of baby boomers. Sixty percent of millennials said they planned to increase their ETF holdings in the next year. If you’re not an ETF investor yet, there are some good reasons to consider following the millennials’ lead.
Lower Costs Make ETFs Popular with Younger Investors
Exchange-traded funds merge characteristics of both mutual funds and stocks into one convenient, cost-efficient package. Like a mutual fund, an ETF contains a collection of underlying securities, including stocks and bonds. The biggest difference, however, is that ETFs trade on an exchange like a stock. The price of an ETF can go up or down as shares are traded. A traditional mutual fund, by comparison, has its price determined once a day, after trading hours have ended.
The traded nature of ETFs makes them appealing to younger investors for two reasons: The initial buy in is often lower, and the operating costs are usually less than those of a mutual fund. With some mutual funds, for example, the minimum purchase is set at $3,000 or more. With an ETF, on the other hand, you can purchase fractional shares. That may be attractive to a millennial who has $100 or $200 a month to build investment wealth.
ETFs also tend to have lower expense ratios compared to traditional mutual funds. The expense ratio represents the annual fee charged by the fund to investors. It’s expressed as a percentage of the total fund’s assets, and the lower this figure, the less you pay in fees. According to the Investment Company Institute, the average expense ratio for an equity ETF was 0.23 percent in 2016, compared to 0.63 for equity mutual funds. A higher expense ratio can take a significant bite out of your investment earnings over the long term.
In addition to lower costs, ETFs also offer simplified diversification. That’s a plus for younger investors who may not have deep knowledge of the market. You can invest in an ETF that tracks a particular sector or market index, such as the Standard & Poor’s 500 index, and get exposure to several different market classes in a single investment. Diversification helps to minimize risk, so that if one part of your portfolio loses value your other investments can pick up the slack. And investing in ETFs eliminates the stress of trying to pick the “right” stocks.
ETFs Are a Tax-Efficient Option for Investors
Asset allocation—meaning what you invest in, based on your goals and risk tolerance—is important, but asset location can also affect your portfolio in a big way. Asset location simply means where you put specific investments. That’s important from a tax perspective.
An employer’s 401(k) may be your first choice for retirement saving. Contributions to a 401(k) reduce your taxable income for the year, and your investment earnings grow tax deferred. If you’ve maxed out your 401(k) for the year, or your job doesn’t offer one, an individual retirement account (IRA) is the next best place to enjoy tax-advantaged savings. After that you can move on to funding a taxable brokerage account. However, what you invest in with each account matters.
ETFs are a tax-efficient way to invest for younger people who may not have access to a workplace retirement plan and are investing in a taxable brokerage account. With an actively managed mutual fund, for example, there’s a fund manager who’s making decisions about which securities to add or remove from the fund. Each time there’s a turnover—meaning assets move in or out of the fund—it can trigger a taxable event for investors. As ETFs typically follow an index, turnover is lower, which means the odds of getting hit with a capital gains tax on fund distributions is reduced.
ETFs can still make sense for millennials and other investors who are funding a Roth IRA. With a Roth you have the benefit of being able to enjoy tax-free growth on your investments in retirement. At the same time, investing in ETFs in a Roth IRA gives you an opportunity to employ more-complex investing strategies. For example, you could use your IRA to buy shares of leveraged ETFs, which may give you performance results similar to trading stocks on margin. The beauty of ETFs is that they can be used by both the novice and the experienced investor to plan for retirement.
Think Big Picture When Investing in ETFs
While ETFs can be a low-cost way to diversify, they do entail risk, just like any other investment. And in some cases a lower expense ratio can be outweighed by high trading costs, especially if you’re trading ETFs frequently. Each time you buy or sell ETF shares, your brokerage may charge a commission, adding to your costs.
Remember, also, that ETFs aren’t the only way to invest. As you shape your portfolio, you should be thinking about your overall objectives, your time horizon, risk tolerance, risk capacity and budget for investing. Taking a well-rounded approach can help you build a portfolio that’s designed to help you reach your investment targets for the long term.