What is an ETF? It’s a simple, diversified way to fuel your dreams. Easily tradable every day the market is open. The pros seem to far outweigh the cons. Is there an ETF in your portfolio today?
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What is an ETF? It’s kind of a cross between a stock and a mutual fund. ETFs let investors of all sizes, including small retail investors, build institutional-quality portfolios with minimum expense.
How do ETFs do that? Exactly how do they work?
ETF = Exchange Traded Fund
Let’s start by breaking down the acronym.
ET = Exchange Traded
ETFs are traded on the major stock exchanges, just like shares of Apple and Microsoft are. If you’ve ever traded individual stocks, then buying or selling an ETF will feel very familiar. It’s traded the same way.
Prices adjust up and down throughout the trading day… not just once after the market closes (like mutual funds). You can go online anytime during the trading day and see exactly what the fund costs at that moment in time.
F = Fund
Similar to a mutual fund, an ETF is a basket of a bunch of different stocks or bonds in a single fund. If you’ve ever owned a mutual fund – especially an index fund – then an ETF will feel familiar. It offers the same built-in diversification. You won’t have nearly as much risk as you would with individual shares of stock.
In a nutshell, an ETF is a pooled investment that gives you exposure to a basket of equities in a sector or index without having to buy individual stocks. Which helps limit your risk.
It’s a mutual fund… except for one significant difference that’s hinted at by its name – exchange traded fund.
What’s So Great About Being “Exchange Traded?”
You probably already have a brokerage account with a company like Schwab or Fidelity. If so, you could easily buy any ETF you want today, simply by placing a buy order in your brokerage account.
What’s more, you can buy an ETF anytime you want, as long as the market is open. Contrast this with a mutual fund. Buy and sell orders for mutual funds are only processed once per day. After the close of trading. With an ETF, you could buy it this morning and sell it this afternoon, if you wanted to.
Ever entered a stop-loss or limit order on a stock? Or bought on margin, or shorted a stock? All these stock strategies also apply to ETFs. But they don’t apply to mutual funds.
You also get the transparency of real-time pricing. Just go to any stock market tracker or your brokerage account. There, you’ll be able to see exactly how much your ETF is trading for at that very moment. No wondering what a mutual fund’s net asset value (NAV) will be at the end of the trading day.
What is an ETF — Pros
Like anything in the investment world, ETFs have pros and cons. Here’s the long list of pros.
ETFs are usually more tax efficient than mutual funds. Mutual fund managers actively trade, which can create taxable gains to shareholders. ETF managers only trade to match changes in the index, promoting tax efficiency.
Most ETFs are passively managed, which means they have lower annual expenses than actively managed funds do. Also, ETF managers avoid labor-heavy daily accounting of redemptions and purchases.
Real time pricing
ETFs offer real-time pricing. On the other hand, mutual funds are priced based on their end-of-day trading price, which no one knows in advance.
Trades throughout the day
You can buy on a dip or sell high.
No minimum investment
This makes ETFs attractive for beginning investors.
ETFs offer diversification, whether across the market as a whole or within a sector or stock type. For example, a technology sector ETF reduces your risk of betting wrong on an emerging tech stock.
Advanced trading strategies
Stock trading strategies are also available for ETFs.
There’s an ETF fund for nearly every taste, style, asset class, or industry. Some track the S&P 500. Others track precious metals, commodities, currencies, or bonds. There are also leveraged ETFs – but those come with significant risk.
They’re just as liquid as stocks, except they don’t settle for two days.
Compelling research shows that passive funds outperform actively managed funds over the long haul.
What is an ETF — Cons
ETFs typically charge lower management fees than mutual funds do. A report from U.S. News noted that the average expense ratio for passive ETFs was only 0.18%… while equity mutual funds charged 0.52% per year on average. That’s almost three times as much… ouch!
ETFs’ flexibility might encourage frequent trading… which could lead to mistiming the market and buying or selling at exactly the wrong time.
If you sell an ETF, you won’t be able to reinvest for two days, because ETF sales aren’t settled till two days after the transaction.
Potential tracking errors
How well does a particular fund achieve its goal? A tracking error is the difference between an index’s return and the fund’s return. Greater tracking error may be linked to less management efficiency and/or greater risk.
So What Is an ETF? A Mutual Fund 2.0…
ETFs have become increasingly popular in recent years, due to their wealth of benefits. And their ability to create wealth and fund your dreams. All with diversification that alleviates the risks of individual stocks.
ETFs are a great option for investors who want to diversify their portfolio in a way that’s flexible, transparent, low-cost, and tax-efficient. And with better average returns than actively-managed funds. Put passively managed ETF funds to work to help you achieve your long-term plans and vision. They’re truly a simple way to fuel your dreams.