I’ve talked in depth about mutual funds on this blog – case in point is the mutual fund basics post a few weeks ago. But what I haven’t talked to you about are exchange traded funds or ETFs. Exchange traded funds have grown in popularity over the past few years. This post will walk you through what they are and why you should consider investing in them.
What Is An ETF?
In a broad sense, an ETF is a hybrid of a stock and mutual fund. It essentially takes the best features of each of these types of investments and combines them into a new type of investment.
More detailed, an ETF is a basket of investments just like a mutual fund is. When you buy a share of an ETF, you are buying hundreds or even thousands of underlying companies. But, unlike a mutual fund that you can only buy into or sell out of at the end of the day, with an exchange traded fund, you can buy or sell anytime throughout the day.
So, if an ETF is down at 10am and you want to sell, you will get a price close to the price you see at 10am, not the price when the market closes at 4pm as you would with a mutual fund.
Other Features of ETFs
Another great feature of ETFs is the low expense ratio. I’ve talked numerous times about how you need to pay attention to the fees you pay when investing in mutual funds. With ETFs, they tend to have low expense ratios. The reason for the low expense ratio is because ETFs tend to track indexes and thus don’t have to pay a portfolio manager and their team to pick and research investments. This saves you money over the long-term.
A final feature of ETFs is that you can easily reinvest dividends and hold fractional shares. Many brokerages used to not allow holding fractional shares, but more and more are open to this idea today. Just note that if you switch brokerages, typically your fractional shares will be sold and turned into cash and your whole shares will be transferred “in-kind” or as-is.
Downsides To ETFs
Of course, you can’t only have advantages to something, there has to be a disadvantage somewhere. The main disadvantage to exchange traded funds is the trading costs. Unlike with mutual funds where you buy and sell shares without a fee, ETFs do charge a fee to buy or sell. If you go the discount brokerage route, you are looking at around $10 per trade.
On the surface, $10 might not seem like much, but it really does eat into your returns. This is the main reason why investor John Bogle is not a fan of ETFs. For example, let’s say you are looking to invest $100 into an ETF at a brokerage that charges you $10 to trade. The cost of that ETF is a staggering 10% ($10/$100)! You would have to invest over $1,000 just to get that trading fee under 1%.
The other main objection to ETFs that Mr. Bogle has is that they encourage short-term speculation. What he means by this is that you can buy and sell frequently throughout the day, causing not only higher fees (lower returns) but the more investors that don’t invest for the long-term are only creating more volatility for everyone else.
Should ETFs Have A Place In Your Portfolio?
I feel that ETFs have a place in most people’s portfolios. In fact, my entire portfolio with Betterment is invested in ETFs and it has been performing great for me. The keys to make ETF investing worth it are as follows:
- Find low cost/free trades: Betterment doesn’t charge me any fees to invest in the ETFs I have with them. I also have money over at Schwab. If you invest in Schwab ETFs or a few select others, there is no trading fee there either. I know at Fidelity, you can trade iShares for free too. My suggestion is to pick a family of ETFs to invest in and then see where you can trade them for free. To find other brokers that offer no fee trades, check out my online broker comparison chart.
- Pay attention to fees: I know I said that most ETFs track indexes, but the key here is that “most” do. There are still a handful of ETFs that are actively managed and have the expense ratio to prove it. Do your homework and verify that the ETF you are looking at is an index exchange traded fund and carries with it a low expense ratio. To verify you are paying as little in fees as possible, check out the free service provided by Personal Capital.
- Don’t trade, invest for the long-term: I have stocks in my play account that I trade. Even though I can trade ETFs like stocks, they are a long-term investment for me and I make it a point to buy and hold these investments. They are a great partner to a mutual fund if you cannot find a good mutual fund to complete your allocation with.
Overall, exchange traded funds, or ETFs are a great investment vehicle for you to consider investing in. Just make sure you follow my tips so that you can save the most money on them. As times goes on, I am certain we will begin to see more and more variations on ETFs making the choice of picking out low cost versions harder and harder. But for now, know that the majority of ETFs are worth looking into.
Readers, do you invest in ETFs? Are there any features I didn’t talk about that are important when considering investing in ETFs?