Question: How are exchange-traded funds different than mutual funds? Should I invest in ETFs?
Answer: In recent years, financial planners have advised clients to invest in indexed mutual funds with low expenses to reach financial goals with lower risk. An index mutual fund holds certain types of stocks, bonds or other assets that perform in a similar way to a benchmark or index. For example, an index fund that follows the Standard & Poor 500 invests in 500 stocks that are generally considered representative of the U.S. stock market.
The purpose for both mutual funds and ETFs is to reduce risk. If you own one stock and the value drops, you have lost a significant portion of your assets. If you own 30 stocks and the value of one drops, it doesn’t affect your investment appreciably.
Exchange-traded funds are similar to mutual funds in that securities are purchased for the ETF that mirror the performance of an index such as the S&P 500 Composite Stock Price Index. ETFs are not mutual funds, however. They cannot be purchased directly from a company but are bought and sold as stocks. As with stocks, you must work with a broker and pay a commission to buy and sell ETFs shares.
Unlike mutual funds, the price per share of an EFT is not based solely on the net asset value of its underlying holdings. Thus, you can find ETFs selling for less than their value (or for more than their estimated value).
There are several advantages of ETFs over mutual funds: 1) management fees are often much lower; and 2) many are more tax efficient. For people who are investing for the long term, the annual expense ratios are generally much lower for ETFs than for index mutual funds, making them a good choice. In addition, the holdings of ETFs change infrequently, resulting in lower trading costs and capital gains tax.
You can purchase a variety of ETFs to create an investment portfolio that covers a wide variety of market benchmarks including U.S. stocks, foreign stocks and bonds. Financial advisers suggest that a portfolio with variety offers a good return on your investment with lower risk.
There are drawbacks to ETFs. In order to purchase an ETF, you must buy through a broker just as you would purchase stocks. Because of the commissions, ETFs are not a good choice for people who buy and sell assets in their portfolios frequently. ETFs will also be more costly for people who invest on a regular basis. The commissions would significantly reduce the return on your investment. Consider buying ETFs through discount brokers.
If you have just paid income tax on the yearly distributions from your mutual funds, you’ll immediately be drawn to another ETF advantage. Shares of ETFs are not required to be distributed every year, and often you will owe tax only when you sell ETF shares. However, ETFs do make capital-gains and dividend distributions, so tax is sometimes involved.
Cautions regarding ETFs include: 1) avoid buying ETFs that invest in similar stocks; and 2) some of the new ETFs are based on obscure types of indexes and have very limited track records
For more information, check Web sites at www.vanguard.com, www.etfconnect.com and www.morningstar.com.
Judy McKenna, Ph.D., CFP, Family Economics Specialist, Colorado State University Cooperative Extension, email@example.com