Exchange-traded funds (ETFs) have been around for nearly 30 years, but the idea behind them goes back even further. ETFs take the phrase, “don’t put all your eggs in one basket” and turn it into a product you can purchase based on different criteria or individual investment goals. Today, ETFs comprise large portions of retirement portfolios and taxable trading accounts, but they aren’t always suitable for every investor. Read on for your ultimate guide to exchange-traded funds. Or, if you have immediate questions, contact our team at Good Life Mt. Pleasant today! We can’t wait to help you work towards your financial goals.
How Do ETFs Work?
An ETF is a basket of stocks, bonds, or other securities, similar to a mutual fund. ETFs are designed and launched by different companies and asset managers, such as Blackrock, State Street, or Vanguard. ETFs follow a particular investment theme and allow investors to buy a wide range of stocks within a single, tradable product.
ETFs come in many different shapes and sizes. Some track the market as a whole, while others follow specific sectors, asset classes, or countries. In addition, some ETFs use leverage and make sophisticated trades that aren’t for novice investors – there’s something for everyone when it comes to ETFs!
ETFs are similar to mutual funds but have a few distinct differences. Mutual funds also offer a basket of assets under a single product; however, they aren’t traded on exchanges. Instead, mutual funds buy and sell assets after the trading day ends and use Net Asset Value (NAV) to determine the fund’s share price. Additionally, mutual fund investors buy and sell shares directly with the fund company, unlike ETF investors who trade with each other on the exchanges during the trading day.
When trading ETFs, knowing what you’re investing in and who you’re investing with is essential. Use the following factors to help guide your decision-making when buying ETFs.
- Active vs. Passive: Active ETFs have a living, breathing manager picking the assets under the ETF’s umbrella. Managers buy and sell assets based on their models or timeframes, usually trying to beat market averages. Passive ETFs don’t have a manager; they track an index like the S&P 500 or Russell 2000 and are cheaper on average than active funds since there is no manager to pay.
- Weighting Methodology: Each ETF will have rules based on which assets are added or removed to the portfolio. Most of the larger ETFs use a market-cap weight system, where the stocks with the largest market cap have the largest share of the assets in the ETF portfolio.
- Expense Ratio: Whether active or passive, sector or broad-market, leveraged or unleveraged, all ETFs carry a price. The expense ratio attached to an ETF shows how much it costs an investor to buy into the fund.
Benefits of Owning ETFs
Tax Efficiency – Since ETFs are traded on exchanges amongst individual investors, the fund company doesn’t need to buy or sell assets frequently to meet investor redemptions. This means fewer capital gains distributions and fewer taxable events for ETF investors versus mutual fund investors. As a result, ETFs are a better vehicle than mutual funds if trading in a taxable account.
Liquidity and Control – An ETF is traded on an exchange like the NYSE or NASDAQ. Unlike mutual funds, ETFs can be bought and sold throughout the trading day, which allows for more precise entry and exit points once an investor’s objectives have been met. Mutual funds can only be sold after the trading day ends, and NAV can be computed.
No Minimums – Many mutual funds require a ‘down payment’ for access to the fund, usually starting with $3,000 but sometimes more. You would need at least $3,000 for an initial investment in such a fund, but ETF investments can be started for a single share’s price.
Drawbacks of Owning ETFs
Overtrading – Since ETFs are traded on exchanges, and most brokers have dropped commissions, the impetus to trade can be strong, sometimes too strong. Mutual funds can’t be flipped during the day, but ETFs can be bought and sold anytime during open market hours, often resulting in overtrading.
Advantages Fade in Tax-Deferred Accounts – Many retirement vehicles like 401(k) accounts don’t allow ETFs to be owned, only mutual funds or annuities. Individual Retirement Accounts (IRAs) allow ETF ownership, but some 401(k) plans don’t allow them, nor do any other exchange-traded product. Additionally, the tax benefits of owning ETFs fade a bit when holding them in a tax-advantaged account. For example, a Roth IRA provides tax-free growth on all contributions. A capital gains distribution into a tax-advantaged account won’t have the same drawbacks as a similar distribution into a taxable account.
Other Careful Considerations
EFTs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETFs net value asset (NVA). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Investing in mutal funds involves risks, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
Work Towards Your Goals Today
We hope you enjoyed this guide to exchange-traded funds! If you have any additional questions, remember to contact our team of financial advisors at Good Life Mt. Pleasant.
Whether you’re new to investing and want some guidance, saving for a new home, planning for retirement, or have some other financial goal in mind, we are here to help you build a plan for success. Contact us today to get started!
The opinions voiced are for general information only and are not intended to provide specific tax advice or recommendations for any individual.