Exchange-traded funds (ETFs) are collections of different securities, providing investors with a way to diversify their holdings with one purchase. ETFs trade like individual stocks, and like stocks, you can buy and sell ETF shares at any point during the trading day at the current market price.
To determine whether these funds make sense for your portfolio, it’s important to understand their advantages and disadvantages compared to other common types of investments.
How ETFs work
When you purchase shares of an ETF, you invest in the underlying investments of the fund. These investments typically consist of stocks, bonds, or a mixture of the two. They can also hold other types of investments, such as commodities and real estate.
ETFs often have an investment objective in mind, which guides the type of asset classes they purchase.
For example, a growth fund may focus on fast-growing companies whose shares have been appreciating in value. In contrast, a fixed-income fund may invest in bonds, which can produce lower long-term returns, but with lower short-term volatility, or fluctuations in value.
Additionally, fund managers may use either passive or active strategies to manage the ETFs:
- Passive Funds: Some are set up to track a market index, such as the Dow Jones Industrial Average, or the S&P 500. By aiming for a mix of stocks that mirrors the index, managers can avoid having to make frequent decisions about which investments to buy or sell. These types of funds are known as passive ETFs and generally feature lower management fees.
- Active Funds: Others are set up to achieve investment objectives or to attempt to outperform a benchmark index. For example, an active fund might try to minimize stock price volatility, or to track a certain sector, such as technology. Actively managed funds are newer and less common than their passive counterparts.
Fund managers usually set these funds up with a mix of stocks and bonds that they believe will meet their objectives, and typically make adjustments over time to these portfolios to keep them on track. Because of this increased manager activity, actively managed ETFs generally feature higher management fees than index funds.
All funds issue a fund prospectus describing the investments the fund makes, the investment rationale behind those investments, and the fund’s overall investment objective.
ETFs vs. mutual funds
If you’re familiar with mutual funds, you might think that the description of an ETF sounds a lot like the description of a mutual fund. In fact, the two types of investments are similar. Mutual funds pool investor money and use it to invest in a group of securities as well.
Each is a tool that can help you build a diversified portfolio, which can help reduce risks associated with buying individual assets. If a particular company or market sector has a difficult month, the relatively stable performance of the other stocks in an ETF or mutual fund dampen the effect on your overall portfolio.
The key difference between mutual funds and ETFs lies in when and how they are bought and sold. A mutual fund sells shares directly to investors, or through a broker for the fund. You don’t buy shares from other investors, as you do with an ETF.
And while you can place an order to buy or sell mutual fund shares throughout the day, actual trading occurs only once per day, at the end of the trading session, when mutual funds calculate the price of their shares—also known as their net asset value (NAV). Your trade will be executed when the fund’s NAV is calculated, and the price at which you buy or sell shares will be based on this number.
Exchange-traded funds first sell their shares to one or more intermediaries, usually financial institutions known as broker-dealers. Those intermediaries buy and sell shares of funds on the same stock exchange they use to buy and sell stock shares of publicly traded companies. This setup provides ETF investors a little more flexibility than mutual funds when it comes to buying or selling. And because these funds trade on exchanges all day long, their prices change throughout the day based upon supply and demand.
Advantages of ETFs
ETFs offer many of the same advantages mutual funds do, such as diversification through one investment. You can also choose ETFs built around specific investment strategies. They also may have lower fees and expenses than mutual funds.
Mutual funds may charge load fees, which are a sales charge for buying shares, in addition to management fees, distribution fees known as 12b-1 fees, and other expenses. By contrast, ETFs do not charge load fees or 12b-1 fees. Shop around to make sure you get the lowest-cost alternative available.
Also, the fact that ETF share prices change throughout the day means investors could have greater flexibility in buying and selling shares. With ETFs you know the market price of a share when you decide to initiate a trade, unlike with mutual funds, where you have to wait until the end of the day to find out the share price.
ETFs may also offer more up-to-date information about what’s in the fund than mutual funds. Many disclose their public holdings every day, while mutual funds are only required to disclose their holdings quarterly.
Finally, ETFs may be more tax-efficient than similar mutual funds. When ETFs sell their underlying holdings, they do not pass capital gains tax on to investors, as mutual funds sometimes do. That advantage is not necessarily universal, however, so it’s worth consulting with a tax professional before making an investment decision on that basis.
Disadvantages of ETFs
While many ETFs aim to track a benchmark index, sometimes their performance can either fall behind or beat their benchmark. This is called a tracking error, and it’s a measure of variability from the index’s performance. A large tracking error can clue you in to issues with fund management, and can be an important measure to look at before you buy a particular fund.
Exchange-traded funds can also have limitations when it comes to diversifying internationally. While there are many domestic ETF offerings, there are relatively few international ETFs. So if you are looking to diversify your portfolio with international investments, your options may be limited, for now.
Additionally, not all funds are created equal. While many of them track major indexes like the S&P 500, there are some, such as leveraged ETFs, that use more exotic investment strategies that could be more risky for investors. Before investing in any ETF, be sure you understand a fund’s underlying investments and the strategies it uses to invest.
When you purchase ETF shares, you may have to pay a brokerage fee. Investors are likely to find commission-free ETFs online, but there are certain circumstances—such as working directly with a broker—where you may be charged a fee. These fees can take a bite out of your returns, especially if you do a lot of trading.
How to Buy ETFs
Because they trade on exchanges, when you invest in exchange-traded funds, you follow the same process you use to purchase a stock: You place a trade with a brokerage firm, which then buys or sells shares of the ETF inside your account.
As with stocks, different brokerage accounts offer different commissions, fees, and other features on ETF trades, so it’s worth shopping around to find the most suitable option for your particular situation. You may also choose to hold ETFs inside retirement accounts such as IRAs.
Visit Stash to learn more about these funds and the types of ETFs we have available for potential investors.