Exchange Traded Funds can have its advantages over traditional stocks.
The old adage goes, “Don’t put all your eggs in one basket.” That’s very applicable to your finances, particularly when looking at your investments. Diversifying with a number of different types of investments is a wise idea, and one of the upstart investment funds these days is the Exchange Traded Fund (ETF).
But what the heck is an ETF? According to Investopedia, an online dictionary for stock market terminology, an ETF is a “security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.”
For those of us who are unfamiliar with the ways of securities and stocks, the concept seems infinitely complicated from the outside. But the gist is that an ETF and a stock are very similar except the way they act in relation to the market.
A history
ETFs have been in existence in the U.S. since the late 1980s, but the U.S. Securities and Exchange Commission authorized the creation of actively managed ETFs as recently as 2008.
This type of fund tracks whatever index it’s sold for — whether it be the Nasdaq, the S&P 500 or the Dow Jones. You purchase shares of an ETF, which is a portfolio that mimics the yield of its assigned index.
There are currently around 1,500 ETFs trading on indexes in the U.S.
ETFs vs. stocks
While an ETF looks very much like a stock on the outside, it offers advantages stocks don’t. ETFs trade on the market just like stocks, which means you can short sell or hold onto them for the long term.
Also, like stocks, ETFs are priced and traded throughout the regular trading day through a broker. Other mutual funds are priced once markets close at the end of the day. These features offer investors incredible flexibility.
And because the fund is based on an index rather than shares in a single company, the fund is much more diversified and trade in much larger volumes than stocks. The bottom line is that because they trade in high volume, ETFs also prove to be less risky and less expensive while still being highly liquid (or easily converted into cash).
As aforementioned, ETFs are unlike stocks and other types of index funds in that they don’t try to outperform its given index. They only replicate their given index.
Benefits
In addition to selling easily like a stock, the ETF has a number of other advantages. Because ETFs are passively managed, they incur lower administrative costs. Some mutual funds cost one per cent or more annually in admin costs whereas an ETF usually costs only around .20 per cent.
ETFs are also more efficient when it comes to taxes. They generally don’t see as many securities trades, which means fewer taxes on distributions for you, the investor. And fewer taxes and administrative costs mean your investment dollars are working harder to return more money.