Exchange traded funds (or ETFs) are open-ended investment companies that can be traded at any time throughout the course of the day. Typically, ETFs try to replicate a stock market index such as the S&P 500, a market sector such as energy or technology, or a commodity such as gold or petroleum. In short, ETFs are similar to index mutual funds, but are traded more like stocks.
As you would expect, ETFs along with all investment products, have their share of advantages and disadvantages. It’s important to understand these differences as you consider how to invest your money.
ETF’s provide more flexibility than mutual funds. Because ETFs are listed on an exchange, you can buy and sell them at whatever price they happen to be trading at during the day, just as with stocks. Mutual funds, by contrast, are priced only once, at the end of the trading each day. And, because ETFs trade like stocks, you can also buy them on margin, that is, buy shares with borrowed money in hopes of magnifying your gains.
Another advantage of ETFs is their tax-efficiency. When a mutual fund manager sells a stock for a gain, shareholders in the fund are accountable for the taxable gains, regardless of whether they’ve sold their fund shares or not. Since ETFs trade on exchanges like stocks, you’re usually buying shares from or selling them to another ETF investor, so the ETF itself doesn’t have to buy or sell securities. Which means there aren’t taxable gains to be passed on.
Low costs ETFs’ biggest advantage is their low annual operating costs. Their expenses are not only well below those of traditional mutual funds, but in many cases even less than the expenses of their already cheap index fund counterparts.
Sounds pretty good so far, right? Now consider the disadvantages.
The biggest disadvantage to ETF investing is that you’ve got to buy them through a broker. Even low fees and brokerage commissions can seriously erode ETFs’ inexpensive advantage, especially when investing small sums of money.
For example, if you were planning to invest, say, $100 a month in ETFs, even a cost of just $10 per trade would mean 10 percent of your investment is lost before you even begin. Your ETFs’ price would have to rise 10 percent just to recoup your buying cost. And, you have to pay a commission when you sell too!
Like I’ve mentioned previously, using an online broker like Zecco that provides free online stock trades can remove this major disadvantage, and opens up the ETF investing possibilities.
The increased flexibility can also be a disadvantage. The ability to move in and out of ETFs quickly can lead to the temptation of trying to jump into sectors of the market you believe are about to climb trying to jump out just before a sector sinks. It’s called market timing, and I’m against it for the most part.
It sounds like a great idea, but time and time again, the average investor has proven that he can’t do it. Most investors buy into hot sectors after prices have already been bid up and then find themselves selling for a loss after the sector flames out.
Because most investors are following the dollar cost averaging strategy of investing small amounts on a consistent basis, I think mutual funds are generally the better choice. But, under the right circumstances, like investing a large lump sum, wanting more freedom to try to buy on a dip or sale on a peak, or using a free online stock broker, investing in ETFs may be the best bang for your buck.