Exchange-traded funds (ETFs) are growing ever more popular. The investment vehicle was created to combine the best characteristics of both stocks and mutual funds into a combined investment structure, while hopefully leaving out some of the less desirable ones. There are some drawbacks, though, as no investment vehicle is perfect for everyone.
Advantages of ETFs
An ETF is a marketable security that trades on an exchange. It is what is called a basket of assets (such as stocks, bonds, commodities, etc.) that tracks a benchmark. Four of the common advantages of ETFs over mutual funds include the following:
- Tax-Friendly Investing—Unlike mutual funds, ETFs are very tax-efficient. Mutual funds typically have capital gain payouts at year-end, due to redemptions throughout the year; ETFs minimize capital gains by doing like-kind exchanges of stock, thus shielding the fund from any need to sell stocks to meet redemptions. Therefore, it is not treated as a taxable event.
- No Investment Minimums—Several mutual funds have minimum investment requirements of $2,500, $3,000 or even $5,000. ETFs, on the other hand, can be purchased for as little as one share.
- Lower Cost Alternative—The average mutual fund still has an internal cost well over 1%, whereas most ETFs will have an internal expense ratio typically between 0.30-0.95%. Plus, ETFs do not charge 12b-1 fees (advertising fees) or sales charges, as do many mutual funds.
- More Trading Control—Mutual funds are traded once per day at the closing NAV price. ETFs trade on an exchange all throughout the trading day, just like a stock. This allows you greater purchasing/selling price control and the ability to set protection features, such as stop-loss limits on your investments.
Drawbacks to ETFs
Of course, no investment vehicle is perfect for everyone, and ETFs are no exception. Some ETFs are overly concentrated, actively traded ETFs can be expensive, ETFs may contribute to market instability, and many ETFs are based on unproven models.
Examples of Widely Traded ETFs
- SPDR S&P 500: The most widely known ETF, the SPDR S&P 500 tracks the S&P 500 Index
- iShares Russell 2000: Tracks the Russell 2000 small-cap index
- Invesco QQQ: Tracks the Nasdaq 100
- SPDR Dow Jones Industrial Average: Tracks the Dow Jones Industrial Average, which includes 30 different stocks
In addition to tax efficiency and lower costs, the advantages ETFs have over mutual funds are:
Investment strategy and style drift: ETFs are mostly passively managed. This means the investments track an index, such as the S&P 500. The ability of the manager to “drift” from the index is extremely difficult.
Mutual funds are typically actively managed, which means investments are chosen by a portfolio manager. This allows the possibility for a manager to stray from the original investment objective over time.
Transparency: Because ETFs track a specific index, securities owned are transparent. Mutual funds buy and sell securities at various times and amounts, so the securities and percentage of holdings will vary over time. Mutual funds are only required to report their holdings quarterly.