Exchange traded funds (ETFs) are something I talk about from time to time on the show, but I often do it in shorthand that leaves you guessing about this little-understood investment.
I want to take a moment to clarify.
Simply put, ETFs are like buying the equivalent of a mutual fund as if you were buying a stock, straight out of a brokerage account. They typically have a better tax treatment than a mutual fund, plus lower management fees. So while the typical mutual fund has annual management fees of 1.5%, you can buy ETFs with annual management fees of less than .10%!
ETFs were initially designed for the Big Money crowd and weren’t for the average Joe because they had huge expenses when either bought or sold. But they’re now morphing into a product that’s fantastic for individual investors as more players start offering them without any buy/sell commissions.
Charles Schwab, Fidelity, Vanguard and TD Ameritrade are among those with commission-free ETF offerings. The surge of commission-free options has created a lot of interest and now there is more than $1 trillion invested in ETFs.
Don’t get me wrong; it’s not like mutual funds are suddenly a bad idea. It’s just that there is a better idea, in the form of ETFs.
One word of advice about ETFs: Broad works better over narrow when adding these to your portfolio. Stick to ETFs that hold little slices and dices of the top 500 companies in the United States, for example. I’m not a fan of the strategy where people say, “Hey, I think it would be a good idea to invest in Paraguay. I think I’ll buy a Paraguayan ETF!” or something similarly arcane. That’s way too granular than you need to be.
For any mutual fund you own in your retirement account, there is probably an exact equivalent ETF available for you. You make the switch with one phone call to whoever you invest with, and that simple call can save you a ton of money in the long run.
Another unexpected benefit: Say you’re the kind of investor who hires a professional to handle your money, and maybe you pay one percent in management fees, plus the expense of the actual investments.
Well, now you’ll just have the management fee and almost no additional cost for the investments if you’re in just ETFs. So it could now actually be cheaper to hire someone else to manage ETFs for you than it would be to pay for mutual funds that you pick yourself!