Exchange Traded Funds (ETFs for short) are a popular twist on an old theme that has become very popular over the last decade or so. Most investors are familiar with mutual funds - a pooled investment vehicle that provides diversification and professional management in one investment purchase.
We have three learning objectives for this post:
- To understand the differences between ETFs and traditional mutual funds
- To learn how ETFs are traded
- To identify the potential benefits using ETFs can bring compared to individual stocks and traditional mutual funds
ETFs are, in fact, a form of mutual fund with many of the same benefits. Like regular mutual funds, they provide diversification across many stocks or bonds in one investment vehicle. However, most ETFs have very low internal expenses since they are designed to mimic a particular market or industry index, and therefore do not need an active management team. ETFs don’t incur the trading expenses associated with an actively managed fund since there is far less trading activity in an indexed approach. In addition, ETFs are designed to minimize the capital gains tax cost that traditional mutual funds often create. A tax dollar saved is a dollar earned!
The unique aspect of ETFs is revealed in their name. These funds are bought and sold by investors on a stock exchange during all trading hours rather than an end-of-day purchase or redemption processed by the sponsoring fund company. The ETF system creates new shares for you to buy as your order hits the trading system, unless there is someone else wanting to sell shares of the same ETF at the same time at the same price. This combination of traditional order matching and creation of shares creates a very liquid investment. Some of the more heavily traded ETFs can handle orders worth millions of dollars in a single trade without disrupting the market. While ETFs are no-load funds, you may pay a transaction fee to buy or sell, depending on your brokerage account relationship. However, currently many firms offer transaction fee-free trading.
There are many companies sponsoring ETFs with the largest being Blackrock, the world’s largest asset management company. Others include State Street’s SPDR ETFs, First Trust Portfolios, INVESCO, and the list goes on and on. There are ETFs available for investing in all of the most popular indexes, such as the Standard and Poor’s 500, and many more domestic and international stock and bond indexes.
Additionally, there are ETFs for many industry or bond market sectors. Let’s say you had a strong feeling about the financial sector. In this situation, you could buy a financial services sector ETF. This fund would then move in lock step with its target index and pass through any dividends paid by the companies in the index to you.
In more recent years, some ETF sponsors have started incorporating active portfolio management in the ETF vehicle. This may reduce some of the tax efficiency benefits compared to index-based ETFs, but provides the potential for increased performance.
Why consider ETFs instead of individual stocks? The major reason that comes to mind is diversification. Each ETF will hold dozens or hundreds of stocks or bonds and you can obtain exposure to an asset class or a particular market sector without having to research which individual stock to purchase.
Why buy ETFs instead of traditional mutual funds? If you believe that index investing will provide the best, most tax efficient return, you will save on the internal expenses charged by the fund. These fees are usually 0.2% - 0.6% annually in ETFs compared to 0.8% to 1.5% for traditional mutual funds. Lower expenses may translate into higher returns for you.
At Integra Capital Advisors, many of our portfolio models include ETFs along with mutual funds and individual stocks. If you would like to learn more contact us today at (941) 778-1900 or Click Here to schedule a call.