Understanding Exchange Traded Funds (ETFs)
Exchange Traded Funds, ETFs, were first developed in the 1990s as a way to provide lower cost indexed funds (a portfolio designed to mimic the performance of a particular index like the S&P 500 or Nasdaq-100) to individual investors. They have become increasingly popular ever since, growing at an average of 25% annually. In 2003, there were 123 ETFs to choose from. Now there are over 2,000 choices in the U.S. with more than $4 trillion in assets. But you may wonder exactly what they are and how they compare with Mutual Funds. With that in mind, let’s take a closer look at ETFs and some common questions about them.
What is an ETF?
An ETF is a bundle of investments in stocks and/or bonds that trade like a stock on an exchange. They combine the ease of trading stocks and bonds with the benefits of diversification (like a mutual fund) They are relatively cheap funds to buy, sell, and own.
An ETF fund provider selects a variety of assets that can include stocks, bonds, commodities, etc. and creates a bundle of all of them in one giant pot with a ticker symbol unique to that group of assets. Investors may buy a share or shares of the pot. Buyers and sellers trade the ETF shares throughout the market day just like stocks.
In What Ways are ETFs Similar to Mutual Funds?
Like Mutual Funds, ETFs are professionally selected groups of stocks and bonds. Both mutual funds and ETFs allow investors to pool money into the selected group of stocks and bond providing built-in diversification, meaning they are less risky than investing in individual stocks and bonds. In addition, both offer a wide array of investing options with varying levels of risk.
In What Ways are ETFs Different Than Mutual Funds?
1. Pricing and Trading:
The price per share of an ETF is determined by the market like a stock. You can see the price at any time throughout the market trading day as it fluctuates based on supply and demand like a stock. And like a stock, ETFs have more order trading options (for example, limit orders) that give you more control over you purchase price.
In contrast, the price for a mutual fund share is determined at the end of the trading day and is the Net Asset Value (NAV), or the value of all the cash and securities in the fund portfolio divided by the number of shares outstanding, plus any sales charge. You will pay the same price as everyone who bought and sold that day because the price is not calculated until after the trading day is over.
Also, most mutual funds have minimum investment requirements, often $1,000 or more, as opposed to ETFs which do not have minimums. You can buy an ETF for as little as the cost of one share.
2. Fund Management Expenses:
ETFs typically have lower fees than mutual funds. The average US mutual fund charges 1.42% in annual administrative expenses. In contrast, according to ETF.com, the average ETF administrative expenses are .53%.
The typically lower ETF costs are primarily due to the fact that the fund assets are not as actively managed. Though there are passively managed mutual funds that are essentially index funds as well, many are actively managed mutual funds which means they are run by a professional investment manager who essentially tries to “beat the market” buy buying and selling securities within the fund using their investing expertise. Naturally, this active trading expertise costs more than a fund that is index-based (a portfolio designed to mimic the performance of a particular index like the S&P 500 or Nasdaq-100).
3. Tax Implications:
Mutual funds generally have more turnover with the fund than ETFs (remember the more active management we discussed above). Buying and selling within the fund can result in taxable capital gains and investors with taxable accounts (not 401(k)s or IRA’s) will be on the hook for the related taxes. In contrast ETF allow you recognize gains/losses when you sell your shares, giving the investor control of when and how much gain or loss to recognize for tax purposes. As a result, ETFs are generally considered to be more tax efficient than mutual funds.
ETFs have risen in popularity for good reason. But never assume that any investment is low cost without taking a closer look. However, ETFs are generally an affordable and tax-efficient investment (for those with taxable investment accounts as opposed to tax advantaged accounts like 401(k)s and IRAs) which provide investors with both market exposure and diversification.