Since their emergence in the 1970s, mutual funds have permeated the financial industry to become one of the premier investment vehicles for both individual and institutional investors. But experts have often panned the majority of traditional mutual fund offerings, pointing out that they can be expensive, illiquid and relatively inefficient when it comes to taxation. A new breed of funds, however, arose in the early 1990s and still provides many of the same advantages of traditional funds without several of these drawbacks. Exchange Traded Funds (ETFs) are mushrooming in popularity and have begun to supplant their traditional cousins in some areas.
One of the prime advantages of ETFs is that they typically cost a great deal less than traditional funds. Many mutual funds charge a sales load that is assessed either at the time of purchase (for A shares) or charged according to a declining schedule if the fund is sold within a certain period of time (with B shares). C shares investors will usually pay a small amount up front and then another smaller amount if they redeem the shares after a year. Traditional mutual funds also charge ongoing management fees called 12b-1 fees that can equal up to a percent or more of each investor's money per year.
Although there are no-load funds that do not have sales charges, even these funds typically charge management fees of some sort (the average cost for a stock fund is just under 1.5%). ETFs never have sales charges and usually charge little or nothing in the way of ongoing management fees, but investors must pay a brokerage commission to buy and sell them just like a stock or any other publicly-traded security. Investors who have limited means may therefore want to consider ETFs because of their lower overall cost. Investors who make small monthly systematic investments such as $50 per month, however, should remember that there is usually a minimum brokerage charge for their monthly purchase; even a $9.95 commission would constitute a substantial percentage of the amount invested. Those in this category may be wise to stick with a traditional fund that will charge a more appropriate percentage for even a small amount of money.
Investors who are on a tight budget should also consider that since ETFs trade like stocks, they can be bought and sold on margin and sold short. They can also be purchased at a limit price and have trailing stop loss orders placed under them for protection. Traditional fund investors are at the mercy of the markets and can only buy in when the fund's daily price is set at 4 p.m. EST each day. ETFs are therefore popular with market timers and day traders who seek efficient ways to get into and out of the markets quickly and cheaply. Even low-cost, no-load traditional index fund investors can only place a single buy or sell order each day. Investors with limited means who wish to invest in a specific subsector will also probably be able to find an ETF that focuses on precisely their objective, while providing all the advantages of brokerage trading at minimal cost. Small investors can also participate in sophisticated inverse strategies with special ETFs that invest in instruments that move inversely to the markets.
Another key advantage of ETFs is their lower distribution rate of capital gains. Traditional open-end funds that are actively managed often post substantial capital gains distributions every year around November. But most ETFs invest in a set basket of securities that focus on a sector, subsector or benchmark index such as the S&P 500, which typically have very low portfolio turnover. This allows investors to save money on taxes by not having to pay for embedded capital gains each year.
The Bottom Line
ETFs have continued to grow in popularity with both investors and money managers because of their lower costs and greater versatility. Investors who are on a tight budget can often get more bang for their buck out of these instruments than they can from traditional funds. For more information on ETFs, consult your stockbroker or financial advisor.