Exchange-traded funds (ETFs) have only been around for about 25 years.
Nevertheless, they can be a productive part of a diversified portfolio, and they have certain distinct advantages over other types of funds and/or traded assets.
What are they?
ETFs are grouped collections of securities. Like a mutual fund, an ETF pools money from a number of investors into a single fund that purchases a diversified selection of bonds, equities, and other assets with a certain investment goal in mind (income or speculation, for example).
ETFs and mutual funds are managed by professional financial advisors and therefore are equally hands-off for individual investors, which can make them attractive for those who would like their money to grow but who don’t want to personally dabble in the stock market.
How are ETFs different from mutual funds?
ETF shares are traded like stocks throughout the day while mutual funds can only be bought and sold after the market closes, and their price is based on the value of the fund, minus any liabilities, divided by the number of shares. This makes mutual funds less flexible and possibly less lucrative.
What are the advantages?
This difference in how the shares of each fund are handled means that ETFs tend to be more tax efficient than mutual funds.
While investors in both types of funds pay capital gains tax, because the shares of ETFs are traded rather than bought and sold, ETFs produce fewer “taxable events.”
What are the disadvantages?
Since ETF shares are traded, you pay a commission each time shares are bought and sold.
Therefore, it is more advantageous to invest a single lump sum in an ETF and pay a single commission than to invest smaller amounts over a period of time and thus pay several commissions for the same amount of money invested.
Before you invest, ask yourself …
So should you be incorporating ETFs into your investment portfolio? Ask yourself the following:
Are you happy to invest a lump sum?
Lump-sum investing in an ETF is more efficient because it reduces the amount of money you’ll pay in commissions.
However, it often costs less to purchase ETF shares than to invest in mutual funds, which means that your lump sum doesn’t need to be particularly large.
Do you prefer actively or passively managed funds?
ETFs tend to be less actively managed than mutual funds, and those EFTs that are actively managed are often more expensive.
Most ETFs are fundamentally index funds (which means they track a particular financial index), and a talented financial manager can produce more wealth by actively managing the buying and selling of assets.
Are you relatively conservative?
ETFs are not get-rich-quick vehicles. Most are linked to a particular index, which means they will not outperform that index.
If you would like your investments to be riskier but potentially more lucrative, you might want to consider other types of trading.
The bottom line
As with all investments, you cannot be certain that your money will grow, but selecting larger, more widely traded ETFs will insulate you against the widest fluctuations.