Exchange-traded funds (ETFs) have been around for more than two decades, but they’ve only really begun to gain traction among investors over the last few years. One group that’s jumping on the ETF bandwagon in a big way is millennials.

According to Charles Schwab’s 2015 ETF Investor Study, exchange-traded funds made up 41% of millennial investors’ portfolios on average. For younger investors, ETFs offer some clear advantages compared to stocks or mutual funds.  

What is an ETF?

An exchange-traded fund is a type of security that combines certain aspects of both index funds and stocks. Similar to an index fund, an exchange-traded fund may track specific assets such as bonds and commodities or a broader market index like the Dow Jones or the NASDAQ.

The most significant difference between an exchange-traded fund and an index fund is that ETFs trade on the stock exchange. Rather than having its price set once a day after trading has ended, an ETF’s price may change throughout the day as it’s bought and sold.

How ETFs Benefit Millennials

While ETFs have a lot of appeal for investors of all ages, they’re particularly well-suited to millennials for a few different reasons.

Performance

“Beating the market” is a frequently used term in the investing world but it’s a problematic concept. While investors are focused on attempting to outperform the S&P 500, for example, they lose sight of things that diminish their returns, such as taxes and fees. (See also Beat the Market with 'Tax-Free Dividends'.)

With ETFs, the goal is not to beat the market but to match the performance of the fund’s corresponding index. When an ETF is tied to an index that offers a consistent rate of return historically, there’s less pressure to pick the “right” stocks or mutual funds. That’s an advantage for millennials who may not be as knowledgeable about the market as older investors.

Risk

Millennials have earned a reputation for being cautious when it comes to their investing approach. A 2014 report from UBS found that just 5% of investors between ages 21 and 36 were comfortable with an aggressive level of risk.

While ETFs aren’t 100% risk-free, they do have the potential to mitigate losses if the market takes a tumble. Rather than being concentrated on a specific company’s stock, an ETF balances the risk across the different assets it encompasses. For millennials who are wary of taking a gamble on a single stock, an exchange-traded fund is an effective way of hedging their bets.

Transparency

Millennials have grown up in an era where access to information is virtually unlimited. From that perspective, ETFs are right up their alley because it’s possible to see exactly what the fund’s holdings are on a day-to-day basis. By comparison, mutual fund managers are only required to release reports on fund holdings on a quarterly basis, leaving investors in the dark in the meantime.

Diversification

There are a couple of different ways millennials can use exchange-traded funds to inject some diversity into their portfolios. The first is to focus on choosing ETFs by asset class. For example, a real estate ETF might be attractive to investors who don’t have any holdings in this sector and aren’t interested in an REIT. (For more, see: Key Tips for Investing in REITs.)

Another option is to choose ETFs based on target allocation. If you’re heavy on bonds, for example, investing in a stock ETF can even things out. The Investment Company Institute estimates that there are more than 1,400 exchange-traded funds in the U.S. market so there’s plenty of variety in terms of what millennial investors can choose from.

Liquidity

Liquidity can mean one of two things. First, it represents how quickly securities can be converted to cash. Liquidity is also measured in terms of buying and selling an asset without affecting its price.

In general, ETFs are slightly more liquid than mutual funds because of how they’re traded. Leveraged ETFs are an exception to the rule. For millennials who may still be working on building up their emergency savings or don’t keep a lot of cash on hand, the ability to sell securities in a pinch makes ETFs a smart option.

Cost

From a cost perspective, exchange-traded funds offer younger investors who want to avoid high fees a clear advantage. With an ETF, there’s lower turnover in terms of the fund’s assets. Management is passive rather than active, which means fewer administrative costs are passed on to fund investors.

Another cost-related benefit centers on taxes. Because there are fewer trades being made inside the fund, ETFs are less likely to pay out capital gains distributions. Young adults who claim fewer tax breaks because they don’t own a home or have no dependents will appreciate the fact that keeping ETFs in their portfolio won’t drive up their tax bill.

Finally, ETFs may be more affordable regarding the minimum initial investment. With mutual funds, investors may need anywhere from $500 to $3,000 to get started. An ETF, on the other hand, only requires you to have enough money to purchase a single share.

Know the Disadvantages

Even though ETFs tend to have lower expense ratios they can still generate higher costs in other ways. Buying and selling shares of an ETF typically means paying a commission fee to a broker. For active traders, the extra fees can detract from any returns the fund is generating.

Another issue is the potential for an ETF’s liquidity to shrink. If a particular fund has a low trade volume that can be an obstacle to selling shares quickly. A lack of liquidity can also result in a wider bid/ask spread.

The Bottom Line

ETFs offer certain advantages over stocks and mutual funds in terms of accessibility, tax-efficiency and cost. That’s a good combination for budget-conscious millennials who want to invest without overcomplicating things. ETFs are not foolproof, however, and young investors need to be fully aware of the risks involved before purchasing these types of securities. 

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