In contrast to mutual funds, ETFs are generally known for their low fees. Ultimately, investors have flocked to ETFs in recent years (they actually arrived “on the scene” in 1993 as little-known investment options) but they’ve now become a big deal because of low costs, tax savings advantages and solid performance, as well as the fact that they’re usually centered around tracking a benchmark index.
Why is the benchmark index important? A benchmark will compare how well a fund is doing compared to its “peers,” so it gives you a point of reference for evaluating a particular fund’s success or performance.
What is an ETF?
An exchange-traded fund, or ETF, is traded on a major stock exchange and is an investment vehicle for investors to own shares of multiple securities using a single investment. An ETF contains assets such as stocks, commodities or bonds.
In general, ETFs also trade commission-free. They’re usually also less risky because they contain a collection of stocks and bonds, ensuring diversification. In addition, professional fund managers manage the fund for you so you don’t have to waste time and effort putting together your portfolio.
Be aware, however, that some ETFs could carry with them an element of risk. For example, leveraged ETFs have been created to multiply the daily returns of an index or asset class, which brings about more risk than others which simply track an index.
How to choose ETFs
Your personal financial goals should be a major consideration in your decision to invest in an ETF. What is your time horizon? When will you need your money? What is your investing style? Financial situation?
Knowing the answer to these questions will help you make pointed decisions regarding the ETF(s) you’ll choose and also help you devise a consciously diversified portfolio.
Vanguard has a handy tool to help you determine in which ETFs you’ll want to invest. Check out Vanguard’s asset allocation tool/investor questionnaire.
Pros and cons of ETFs
The pros and cons of ETFs should be heavily thought out before purchase. Pros include:
- They’re liquid. Liquidity in this case simply means that you can buy or sell at any time during the trading day. Depending on the asset class you’re invested in, one may be more liquid than another. For example, real estate is less liquid than fixed income.
- They can be less volatile than other types of investments. If you decide to invest in an ETF that tracks a broad segment of the U.S. stock market (such as the S&P 500), this would definitely be considered less volatile than investing in straight stocks. However, be absolutely sure that the ETF you’re considering investing in stays away from volatile stock indexes since they can be volatile. If you’re interested in really low volatility, you could consider investing in an ETF that tracks a bond index.
- They trade like stocks. ETFs can be the best of both worlds, in that they offer diversification and can be purchased on margin like stocks and you can short sell them, too. They also trade at a price that is updated throughout the day, just like stocks. You’ll get real-time pricing every time you buy and sell.
- There’s an ETF for everyone. Depending on what you’re interested in investing in, there are several different asset classes you can choose from, including real estate, fixed income, commodities, equities, and securities, etc.
- More tax-efficient than mutual funds. If you need to sell an ETF, you can sell it just like a stock, right? Therefore, it’s sold and done, and there is no capital gains transaction for the ETF until the fund is redeemed.
- They may not actually be cheaper than mutual funds. You’ll want to do your research to find out if the ETF you’re considering is as cheap as others that are similar.
- You’ll have to pay commissions to buy shares. ETFs trade like stocks; therefore, you’ll pay a brokerage commission every time you buy or sell shares.
Why ETFs over stocks?
In sharp contrast to trading one single stock, an ETF can showcase a broad range of securities, offering more diversification compared to one stock. ETFs can also trade like a stock, which means that certain features of stock trading are the same as with ETFs. Here are a few of those specific features they have in common:
- You can purchase ETFs and stocks on margin.
- You can trade futures and options with both.
- You’ll trade both stocks and ETFs on a stock exchange, such as NYSE.
- Prices change throughout the day, and shares can also be shorted in the event that either a stock or ETF price begins to fall.
Despite these similarities, many choose ETFs over stocks simply because of the diversification that’s inherently available in ETFs.
Commissions and fees
Because ETFs trade like stocks, you’ll need to pay commission to a broker every time you buy or sell shares. Most brokers charge a small fee (typically under $10) to buy or sell an ETF.
However, there are certain families of ETFs that trade commission-free and those are worth looking into. For example, Fidelity doesn’t charge commissions for a specific group of its iShares ETFs. These types of commission-free ETFs are worth looking into; however, they’re typically not the best-performing ETFs by the various brokers.
In general, it’s best to compare and research those ETFs you’re interested in and compare them to what you’d pay for regular stocks, mutual funds and more.
Benzinga has compiled a list of a few of the best ETFs, and they include the following:
|ETF Name||1 Year Return||2 Year Return||Expense Ratio|
|iShares Core S&P 500 ETF (IW)||13.95%||13.25%||0.04%|
|SPDR S&P 500 ETF (SPY)||13.54%||12.75%||0.09%|
|Powershares Dynamic Large Cap Value ETF (PWV)||2.56%||9.36%||0.57%|
|Vanguard Large-Cap ETF (W)||13.77%||12.74%||0.05%|
|iShares Core S&P Total US Stock Mkt ETF (ITOT)||13.88%||13.12%||0.03%|
|Schwab US Broad Market ETF (SCH)||13.70%||12.64%||0.03%|
|Vanguard S&P 500 ETF (VOO)||13.64%||12.85%||0.04%|
The beauty of an ETF is that there truly is something for everyone, and the other major advantage is that passively managed funds like ETFs can beat managed funds over time. If you’re interested in finding something that won’t eat up your money through expenses, or something you’d like to hold for the long term, seriously consider an ETF for your portfolio.