Exchange-Traded Funds (ETF’s) were first introduced to the stock market in 1993. However, there are now over 900 ETF’s offered on the New York Stock Exchange. So what’s the big deal? The old-school mutual fund manager would tell you that ETF’s are “just the next big thing” or that the growth is the result of “aggressive marketing.” But when you see the benefits of ETF’s below, you’ll realize that there is much more to ETF’s, and that mutual fund managers may just be trying to keep your business by bashing ETF’s.
Lower Costs – ETF’s and mutual funds have built-in costs called expense ratios. This is the fee that the manager of the fund is paid. ETF’s typically have much lower costs than mutual funds because they track an index; they don’t incur the high overhead costs (such as research /management fees) that an actively-managed mutual fund incurs.
Tax Efficiency – Mutual funds typically have higher turnover (buying and selling of individual securities inside of the fund) than ETF’s. The mutual funds are then required to pass-through any taxable capital gains to their shareholders that are incurred. Pass-through capital gains can greatly reduce an investor’s net after-tax return. Since ETF’s track an index and don’t have a lot of buying and selling taking place inside of the fund, they incur minimal pass-through capital gains. This allows the investor to defer most of their taxes until they actually sell the ETF.
Intraday Liquidity – The liquidity of an investment is determined by how fast the security can be bought or sold with the least amount of disruption to its price. Mutual funds are priced at the end of the trading day. This means that they can only be bought or sold at the closing price on the day the order is entered. On the other hand, ETF’s can be bought or sold throughout the trading day the same way that stocks are bought and sold. If there is a catastrophic event that causes the stock market to crash, which would you rather own? The ETF that you can sell immediately? Or the mutual fund that you aren’t able to sell until the end of the day, after the market has fallen dramatically? Because of this liquidity feature, ETFs are able to be bought or sold using market orders, limit orders, and stop-loss orders which allows for greater flexibility and risk management than mutual funds.
Diversification – ETF’s are available for every major index and sector of the equities market. There are also ETF’s available for investors who want exposure to the international markets, alternative assets (gold, real estate, etc.), and fixed income.
Transparency – The holdings inside of an ETF must be reported daily. Mutual funds typically report their holdings only once every three months.
I’ve put a Free ETF “Crib Sheet” on our website that was created to categorize the ETF’s offered in a logical order. While this list is not all-inclusive, it is pretty close. Approximately 80% of all available ETF’s are on this list, and 100% of the most common ETF’s from iShares, PowerShares, State Street, and Vanguard are included.
This article isn’t to say that all mutual funds are bad- they certainly have their place, too. I just wanted to point out the benefits of ETFs since they are not as widely-known, and it may be something you want to consider for your investment portfolio going forward.
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John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit https://www.chladekwealth.com.