What is an ETF?

What is an ETF?

An ETF (exchange-traded fund) is somewhat like a mutual fund in the sense that it consists of investors pooling their money to purchase various assets. However, unlike mutual funds which are professionally managed, ETFs are simply designed to track an index or market. This gives them certain cost advantages, but they are not without their drawbacks either.

What ETFs invest in

One of the attractions of exchange-traded funds is the diversity of investments they make. While most are designed to track a certain stock market index such as the S&P 500, they can be found covering a wide variety of investments.  For example, commodities ETFs cover many commodities including gold exchanged-traded funds. More conservative investors can opt for bond ETFs, and currency ETF (or ETCs) are also available. Other ETFs might specialize in a certain region or industry.

Investors should be aware that there is no guarantee the ETF will exactly track the index it is designed to. However, on average, most keep within 1%.

Net Asset Value (NAV) and flexibility

Unlike mutual funds which have the NAV calculated at the end of every trading day, the NAV of ETFs fluctuates continuously. This allows them to be bought and sold throughout the day much like any other stock. They also can be purchased in very low quantities. It should be noted that the share price can sometimes rise above the NAV although the difference is usually minimal.

ETF costs

Most ETFs have lower management, management and other expenses. Furthermore, the majority do not have any 12b-1 fees. This gives them lower expense ratios (usually between 0.1% and 1%) and makes them some of the most cost effective investments. However, their trading costs are usually a fixed amount per trade. When larger amounts are invested, the cost will average out to a very small percentage of the investment, but it becomes significant when purchasing a smaller number of shares. Thus, ETFs are not well suited for automatic investment plans in which a smaller amount is invested every month.

Another cost to consider with ETFs is the difference between their buying and selling prices more commonly referred to as their spread. For those holding their funds for longer periods of time, these spreads are generally low enough not to matter greatly. However, they do make ETFs much less attractive as a short-term investment.

On the other hand, no-load mutual funds purchased directly from the mutual fund company will not have spreads or trading charges. Thus, they are much more attractive for automatic monthly investments and short-term investments.

ETFs vs. Mutual Funds has more information for those deciding between the two.

Investing in ETFs

ETFs are best purchased through a discount broker. While one of the advantages of ETFs is their diversity, it is still important to select different types of funds, such as domestic and international shock, as the amount invested grows. Investors should also look at expense ratios and anything else that might affect the value of their portfolio. Purchased like stocks, those purchasing ETFs need to decide how many shares they will purchase and how much they are willing to pay. It is not a case of simply depositing an amount of money to be invested as it is with mutual funds.

Taxes and ETFs

As with other investments, those who do things right and make a profit will have to face the taxes. One of the advantages of ETFs is that they do not generate taxable events the way mutual funds do. With their structure, they do not need to buy and sell in their securities nearly as often. Thus, most capital gains do not have to be taken until the funds are sold by investors and can continue working for them until that time.

In summary

There is no management watching over investments in ETFs the way there is with mutual funds. Therefore, ETF investors should be at least somewhat more involved in the market. On the other hand, the record of mutual funds shows that the fees from professional management often more than eat up any extra revenue the management may bring in. Thus, ETFs make a good investment choice for many, particularly those who make less frequent, but larger investments, and those who intend to keep invested for longer periods of time.

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