Exchange Traded Funds, Explained

Investors flock to ETFs for minimal costs, maximum diversity.

Exchange Traded Funds

Exchange Traded Funds have been around since 1993, but they didn't really gain in popularity until a decade later, going from a few dozen offerings in the mid-1990's to the more than 600 today. ETFs are like mutual funds in the sense that they allow investors to hold a stake in dozens or even hundreds of different companies with a single purchase. That can give investors instant diversification in their portfolio while spreading out the risk of sector-specific plays among multiple companies.

But ETFs are different in several key ways which may explain why they are quickly surpassing their older cousin, the mutual fund, in appeal. Among those are lower costs and taxes for investors.

Like any investment, you need to do your research before placing an order. And with hundreds of different ETFs to choose from, that could take a while, even if you have a clear idea of what your investing goals are. What follows is a primer to get you up to speed on what ETFs can and can't do and how you can start investing in them.

What are ETFs?

ETFs track an index, a commodity, bonds, or a basket of assets like an index fund. They take the "exchange traded" portion of their name from the fact that they are traded like securities on major exchanges, and even have their own stock symbols just like individual, publicly-traded companies. But they are funds in the sense that each share of an ETF represents an investment in several different issues.

Unlike mutual funds, which are priced daily at the end of each day's trading session, the prices of ETFs fluctuate throughout the day as they are bought and sold. That makes them easier to buy and sell. You only need a discount brokerage account to start buying and selling ETFs. Additionally, you can short ETFs or place limit orders, in which you automatically purchase shares when they hit a certain price.

Most ETFs track an index, such as the Nasdaq or the Dow Jones U.S. Technology Index. On average, ETF taxes are ½ of those levied on mutual funds and expense ratios are about 1/3 of those charged by actively-managed mutual funds.

Should I Invest In ETFs?

We've all seen the studies where monkeys or a dart thrown blindly at a stock table do a better job of picking stocks than professional fund managers. ETFs simplify the process of buying stocks by allowing you to invest in a wide range of stocks that track an index, a sector, or another variable.

Take, for instance, the first ETF, which tracked the performance of the S&P 500. While the S&P 500 can fluctuate wildly from year-to-year, over time it has reliably delivered annual average returns of 4.5%, outpacing annual inflation of 2% and allowing investors holding them for the medium- to long-term to comfortably grow their portfolios. An actively-managed mutual fund may beat 4.5%. But then again, it may not.

Other ETFs target different kinds of stocks and sectors. Maybe you want to increase international exposure in your portfolio, or you want to bet on biotechnology without having to figure out which individual company will have the next big breakout product. Maybe you want to focus on small- and large-cap companies. There is likely an ETF that can help you.

How Much Do I Need To Get Started Investing In ETFs?

Another reason why ETFs have become so popular is that they offer a relatively-low bar for entry for individual investors. While some mutual funds have minimum investment requirements and others have fees and transaction costs that make them unappealing to smaller investors, most ETFs are a good place to start for investors with under $1,000 to get started.

ETFs are cheap because they're based on indexes and sectors: you don’t need a team of analysts poring through algorithms trying to figure out where to put a lump of the fund's equity. Most ETFs charge a fee of 0.20% or less. More focused ETFs may charge closer to 1%, but the savings over mutual funds can amount to tens of thousands of dollars over a 30-year investing window for investors putting aside as little as $500 per month.

ETFs Are Flexible

Because ETFs are traded like stocks, they offer a lot of flexibility. They can be bought or sold whenever markets are open. Their low fees are also appealing to dollar cost average investors, who add small amounts at regular intervals to build their portfolio over time.

While most investors like ETFs because of their simplicity, they can be more complex. ETFs can be shorted, hedged and bundled. Investors can also buy options on ETFs.

More Liquidity, Less Volatility

Because they can be bought and sold throughout the trading day, ETFs offer their owners liqudity. In other words, you can usually sell your holdings and retrieve the proceeds from the sale much more easily.

At the same time, ETFs act as a hedge against volatility. When you invest in a single stock, you're at the mercy of that individual company's performance. One bad move by management can erase your margins. Because ETFs cover a number of issues, those bad news events have less of an impact on your holdings.

One ETF strategy takes advantage of this by investing cash that would normally be held in your brokerage account's money market fund in an ETF. An ETF tracking a bond index, for example, may offer almost as much security as a money market fund, while offering more upside potential over time.

What's Are The Tax Implications Of ETFs?

Mutual fund managers are constantly buying and selling shares, incurring steep capital gains taxes which are passed onto investors. ETFs occasionally need to sell and buy shares to rebalance, but not nearly as frequently as a mutual fund, keeping tax costs low.

Those taxes are taken out of annual dividends and are significantly cheaper than the taxes racked up by mutual funds. For ETF investors, the big tax event comes when you sell your shares and pay capital gains taxes on your profits.

How Come My S&P 500 ETF Rose Or Fell More Than The Actual S&P On A Given Day?

Keep in mind that most ETFs are designed to "mirror" a certain index. Some ETFs may include shares of every underlying stock in the index that track, but many only purchase a representative sample. Some funds also set aside as much as 5% to invest in other equities.

So while your ETF should closely follow whatever index it was designed to represent, there may be some variance. ETFs issue annual and semi-annual reports which you should study to make sure you understand all of the ETF's holdings.

Beware Of Dividends

If you hold mutual funds in a retirement account, you most likely participate in the fund's dividend reinvestment program, which automatically purchase more shares of the fund whenever you receive a dividend. ETF dividends are different.

In the same way that ETFs trade like stocks, they issue dividends like stocks as well. That means the cash payout will end up in your brokerage account rather than automatically being reinvested. If you want to use the dividend to purchase more shares of your ETF, you're going to have to pay your brokerage's transaction fee. To avoid those fees, look for a broker that allows you to reinvest dividends on ETFs with no cost.

Keep in mind you'll also have to pay capital gains taxes on ETF dividends unless they are in an IRA or employer-sponsored retirement plan, in which case you don’t have to pay taxes until you cash out.

Potential ETF Pitfall #1: Mutual Funds Posing As ETFs

Make sure the ETF you buy is actually an ETF. There are close-ended mutual funds out there that trade during the day like ETFs, and managers of some of those funds have tried to ride the ETF popularity by marketing them as such. Their rationale is that because their funds are exchange traded, they can be called an exchange traded funds.

But they're not the same thing as the "real" ETFs we've been talking about, and you'll notice it once you see the fees they charge. Make sure you read disclosures on a fund's Website before investing, and pay attention o the prospectus. You want to make sure you're getting what you think you're investing in.

Potential ETF Pitfall #2: Brokerage Fees

Some investors don't look past the lower management fees of ETFs and forget to factor in the transaction fee they pay their brokerage every time they buy or sell shares of an ETF. Like a lot of investors, you may be making regular investments over time, such as $500 per month. While this dollar-cost averaging strategy works with mutual funds, each month you're going to be paying transaction fees which eat away some of the savings you're getting on management fees.

For this reason, ETFs won’t be available as an investment option in a lot of 401(k) plans, and you should probably look for a discount broker if you plan to dollar cost average your investment in ETFs. You may sacrifice service, but the lower transaction fees will be worth it as you try to tap into the benefits of ETFs.