When people ask for help with investing, ETFs are usually one of the first things that come up because they are heavily marketed and pushed by the industry. Exchange-traded funds, or ETFs, are a simple way to diversify a small investment, but you need to know how they work to get the most out of your money.
ETFs are similar to mutual funds in that they are a group of investments, but they are traded on an exchange like the NYSE instead of being bought directly from the company that created them. They are also different from traditional mutual funds in how they handle redemptions and how they handle taxes.
Here are five benefits of ETFs over mutual funds:
- There is no minimum investment. When you first start investing, diversification can be expensive if you use traditional mutual funds, which often have a $2500 minimum investment. ETFs are a good way to invest in a wide range of things because there is no minimum amount to invest (other than the market price of one share).
- Less expensive fees: ETFs are no-load funds, so you won't have to pay a redemption fee when you want to sell your position. ETFs are also a good alternative to traditional Mutual Funds because their annual fees are often lower. (Note: When a very small amount is traded, broker's fees may be a higher percentage of the investment than a mutual fund's expenses, but in most of these cases, the amount invested wouldn't be enough to meet most mutual funds' minimum investment requirements.)
- Tax-efficiency: When people sell their shares of a mutual fund, the underlying securities are sold and the capital gains are given to the people who bought the fund. Since ETFs are traded on an exchange and investors sell to other investors, there are no sales of the underlying securities and no capital gains. If the ETF's holdings change, it may have to give out some of its gains, but this should happen less often than with traditional mutual funds.
- Intraday Pricing: Since ETFs are traded on busy stock exchanges, they are bought and sold at market prices instead of the Net Asset Value at the end of the day, which is what mutual funds use. Because of this, you can buy ETFs for more or less than what the underlying assets are worth. This is called arbitrage, and it happens a lot.
- Liquidity: Because ETFs are exchange-traded, a position can usually be sold faster than with a mutual fund, which must be sold at the end of the day. Also, the ability to set a limit order lets investors trade in a way that they couldn't do with a mutual fund. Not all ETFs have the same level of liquidity, though, and you should look at trading volumes and the ETF prospectus to decide if the number of trades is okay for you.
Many of these benefits could also be bad if they aren't used right. For example, the intraday pricing of ETFs could lead an investor to buy an ETF for more than the value of the underlying securities or sell it for less than that value. Also, brokerage fees may have a bigger effect on some investors than management fees and loads do on traditional mutual funds.
ETFs can be a good way to diversify a small or first investment in a wide range of ways, but it's always best to get advice from a professional investor.
In the future, I will talk about the five bad things about ETFs.
