Advantages of Exchange-traded Funds
By Jim McWhinney
It was State Street Global Advisors who launched the first exchange-traded fund (ETF) in 1993 with the introduction of the SPDR. Since then, ETFs have continued to grow in popularity but also gather assets at a rapid pace. The easiest way to understand ETFs is to think of them as mutual funds that trade like stocks. Of course, trading like a stock is just one of the many features that make ETFs so popular. Let's go over these attractive features.
The Benefits of Trading Like a Stock
The easiest way to highlight the advantage of the ETF trading like a stock is to compare it to the trading of a mutual fund. Mutual funds generally are priced once per day, at the close of business. Everyone purchasing the fund that day gets the same price, regardless of the time of day their purchase was made.
Because, like traditional stocks and bonds, ETFs can be traded intraday, they provide an opportunity for investors to bet on the direction of shorter-term market movements through the trading of a single security. For example, if the S&P 500 is experiencing a steep rise in price through the day, investors can try to take advantage of this rise by purchasing an ETF that mirrors the index (such as a SPDR), hold it for a few hours while the price continues to rise and then sell it at a profit before the close of business. Investors in a mutual fund that mirrors the S&P 500 do not have this capability - by nature of the way it is traded, a mutual fund does not allow investors to efficiently take advantage of the daily fluctuations of its basket of securities.
Low Expense Ratios
Everybody loves to save money, particularly investors who take their savings and put them to work in their portfolios. In helping investors save money, ETFs can shine. They offer all of the benefits associated with index mutual funds - such as low turnover and broad diversification — plus ETFs often have lower management fees.
Do keep in mind, however, that because ETFs trade through a brokerage firm, each trade incurs a commission charge. To avoid letting commission costs negate the value of the low expense ratio, shop for a low-cost brokerage and invest in increments of $1,000 or more.
Diversification
ETFs come in handy when investors want to create a diversified portfolio. There are hundreds of ETFs available, and they cover every major index and sector of the equities market. There are international ETFs, regional ETFs (Europe, Pacific Rim, emerging markets) and country-specific ( Japan , Australia , U.K. ) ETFs. Specialized ETFs cover specific industries (technology, biotech, energy) and market niches (REITs, gold).
And ETFs cover also other asset classes, such as fixed income. While ETFs offer fewer choices in the fixed-income arena, there are still plenty of options, including ETFs composed of long-term bonds, mid-term bonds and short-term bonds. While fixed-income ETFs are often selected for the income produced by their dividends, some equity ETFs also pay dividends. These payments can be deposited into a brokerage account or reinvested. If you invest in a dividend-paying ETF, be sure to check the fees prior to reinvesting the dividends, as some firms offer free dividend reinvestment, while others do not.
Tax Efficiency
ETFs minimize capital gains distributions by tracking indexes. Apart from dividend earnings, they normally create a taxable event only when the shares are sold or if the fund is rebalanced. A change in the makeup of an index (and the corresponding charges to the ETF) could also result in a capital gains distribution.
Summary
The reasons for the popularity of ETFs are easy to understand. The associated costs are relatively low, and the portfolios are flexible and tax efficient. This simple, convenient combination results in an investment that some people believe will one day replace traditional mutual funds in most investor's portfolios.