An ETF, or exchange-traded fund, is a type of investment that you buy and sell through a stock exchange or investment company.
But what are you investing in when you buy an ETF? And what’s the difference between an ETF and a mutual fund?
Table of Contents
- What Is an ETF?
- How Do I Invest in an ETF?
- Why ETFs Are Tax Winners Over Mutual Funds
- How Do ETFs Work?
- Advantages of ETFs
- Disadvantages of ETFs
- What Types of ETFs Exist?
What Is an ETF?
Sometimes a name tells you a lot. That’s true in the case of ETFs. They’re exchange-traded funds, which is literal: funds that you can buy on the open market.
ETFs are strikingly similar to mutual funds. You’ll pay an annual fee to cover costs that the fund manager incurs, which is called an expense ratio.
Speaking of fund managers, when you invest in an ETF, you give your money to one of these people and they invest it. If that sounds a bit like investing with a blindfold on, don’t worry, as you can find out a lot about what the manager will do with your money before forking over any cash.
Each fund offers a prospectus, which explains the fund’s intentions, strategy and the types of assets in which the fund invests. ETFs can be invested as narrowly as tracking a single commodity such as gold or as widely as an index fund with a portfolio that tracks thousands of stocks.
What Types of Investments Can ETFs Include?
- Stocks
- Bonds
- Asset allocation (stocks and bonds)
- Commodities
- Currencies
How Do I Invest in an ETF?
Investing in an ETF is no different than buying a stock. You’ll want to do your homework first to determine which ETF you want and which investing company you want to trade through.
Here are the basic steps:
- Enter the ticker symbol of the exchange-traded fund in which you want to invest.
- Determine the amount (in dollars) that you want to invest. ETFs don’t include minimum investment requirements. On platforms that offer fractional shares, you can buy in for as little as $1.
- Submit your trade request and wait for it to get filled. Unlike mutual funds, you don’t have to pre-order and wait until the end of the trading day. You can buy and sell any time the market (and your brokerage company) is open.
You also may need to decide whether you want to reinvest any dividends that your ETF generates through its portfolio (translation: automatically buy more ETF shares with the profits) or get those dividends distributed to you as cash.
Why ETFs Are Tax Winners Over Mutual Funds
If you’re investing in a retirement account, you don’t have to worry about buying and selling, as it won’t increase your tax bill for that year.
However, if you’re investing outside of a retirement account, ETFs have tax advantages over mutual funds.
Buying mutual fund shares involves sending your money to a fund manager. You can’t buy directly from someone willing to sell their shares. Mutual fund managers buy and sell holdings in order to handle money coming into and out of the fund. These additional transactions can generate more tax liability.
In addition, the law requires that mutual funds distribute profits (capital gains). If you’re invested in a mutual fund, the IRS will tax any dividend even if you reinvest that money.
When making an investment, your return on investment (ROI) isn’t the only factor you need to consider. Your costs include taxes (paid to the government), annual expense ratios (paid to the fund manager) and potentially commissions when you buy or sell (paid to the investment company through which you trade).
Those costs are a major drag on your net worth when they’re expensive, so the lower they are the better.
How Do ETFs Work?
Investors buy and sell ETFs when the market is open just as they do stocks.
Each ETF gets a unique ticker symbol used to identify it. Just like a stock, an ETF also includes a “bid” (the highest price a buyer is willing to pay) and an “ask” (the minimum price at which an investor is willing to sell). The difference between those numbers is called the bid/ask spread.
For popular ETFs with a lot of trading volume, the spread tends to be minuscule.
However, the number of available shares within each ETF can vary depending on demand.
The bid/ask spread is dynamic, meaning that the price can change. Sometimes the price gets out of line. In other words, there’s a clear open-market value to the assets that an ETF fund manager invests in; it’s also possible for the “ask” to be higher or lower than the market value price.
When the price gets out of whack, some algorithmic wizardry, potentially along with institutional investors, help bring the price back in line with the underlying value of the portfolio.
If you’re a small investor, this is no big deal. But if you’re a big investor, missing out on 5 cents per share times 10,000 shares is big. Also, if you’re investing in an ETF that’s only moderate or small in volume traded, it’s easier for the bid/ask spread to be much more divided and you can really get stuck paying a bad price.
Advantages of ETFs
Here are some of the biggest positives of ETFs:
- Liquid. Because ETFs trade like stocks, you can buy (and sell) shares when the market is open. You also have more of an ability to choose your entry and exit points in terms of price as opposed to mutual funds.
- Cost-effective. It’s hard to avoid ETF vs. mutual fund comparisons because they’re similar in almost every way. To that end, the right ETFs are often less expensive than their mutual fund counterparts due to a combination of taxes and expense ratios.
- Relative tax advantages. If you’re investing outside of a retirement account, it’s vital to understand to tax implications of your investments. ETFs are better for your bank account than mutual funds when it comes to taxes.
- Diversification. ETFs are not guaranteed to offer immense diversity. But plenty of them do. In fact, ETFs that are index funds are some of the most popular.
- No minimum investment. Typically, you can buy an ETF with as little as $1 if your investment platform allows fractional ownership. Mutual funds usually have investment minimums.
Disadvantages of ETFs
Here are some of the biggest drawbacks of ETFs.
- Lack of tax control. If you own individual stocks, for example, you can decide to sell some losers to offset gains (the basic idea of “tax-loss harvesting”). You give up control of these decisions to the fund manager when you invest in an ETF.
- Lack of portfolio control. This is the same premise. The potential flaw here is that the fund may invest in companies that you’d rather not be involved with. You can avoid this to an extent by researching the fund’s holdings and strategy before buying into it.
- Potential price imbalances. Especially if the ETF is thinly traded (lower volume), the bid/ask spread can be relatively wide. The price may not reflect the value of the underlying portfolio. This is less of an issue with popular ETFs.
- Need for discerning judgment (or at least research). There are a ton of great ETF options along with plenty of less desirable ones. There is a small but important difference between good and not-so-good fund managers when it comes to tracking the underlying index. Some ETFs carry no commissions, whereas others can be prohibitively expensive.
What Types of ETFs Exist?
In investing terms, an ETF can be almost anything. The name “exchange-traded fund” doesn’t tell you much about what asset class or classes you’re investing in. Stocks are common, but an ETF can exist without a single stock in it.
Here are just some of the kinds of exchange-traded funds that exist:
- Index funds: Can be mutual funds or ETFs. They track underlying indexes such as the S&P 500.
- Equity funds: Portfolios focused on stocks. There are a variety of choices, including international or domestic, value or growth and a focus on small-, mid- or large-cap companies.
- Bond funds: Choices here include government, corporate and municipal bonds as well as short-term or long-term bonds.
- Industry funds: Invest in an industry-tracking or “sector” ETF, and you’ll get exposure to, say, a basket of tech company stocks.
- Commodity funds: Popular commodities include precious metals such as gold and natural resources such as oil.
- Currency funds: These track the value of a currency or of multiple currencies (the Euro, for example).
Final Thoughts
Clark thinks you should take advantage of all your retirement investment options before putting money in a non-retirement account.
Even though his first recommendation usually is to invest in a target date fund, Clark thinks that investing in a mix of total stock market, bond and international index funds is also good strategy.
If you’ve maxed out your retirement account options, or if you’re otherwise looking to invest in a non-retirement account, putting money in the ETF version of an index fund is a good way to go.
All of the index fund types Clark likes exist as ETFs, which are typically better than mutual funds because of tax implications. ETFs also offer inexpensive diversification, which is key to the type of long-term investing that is geared toward retirement.
