Exchange Traded Funds
An exchange traded fund, or ETF, is very similar to a traditional mutual fund. The biggest difference between the two is ETFs trade all day long on a stock exchange while traditional mutual funds trade once per day. The price of an ETF fluctuates throughout the day and may or may not be in line with the price of the ETF’s underlying securities. Traditional mutual funds, however, trade at one price at the end of each day, and this price reflects the actual value of the underlying securities.
ETFs come in a wide variety of categories. For example, investors can buy ETFs that track the broad U.S. market and the global stock market. Additionally, there are ETFs that invest in a single asset category such as small-cap stocks or commodities. The majority of ETFs are index funds, meaning their goal is to closely track the performance of a particular index. Some ETFs are actively managed by a portfolio manager who picks securities for the portfolio in an effort to outperform a particular index.
Benefits and risks of ETFs
While we think it is best to use actively managed mutual funds to build an investment portfolio, ETFs offer certain benefits that are worth understanding.
ETFs trade like a stock – The ability to trade ETFs like a stock is often considered their greatest benefit. This can be beneficial for short-term traders and those trying to time market movement. However, it can be difficult to consistently make money by trading ETFs on a short-term basis.
Simple diversification – Investors can build a well-diversified portfolio with ETFs that hold a broad selection of stocks in the U.S. and around the world. Additionally, investors can buy broadly diversified bond ETFs that invest in U.S. and non-U.S. bonds. Using only ETFs, it is fairly easy for investors to build a diversified portfolio that has global exposure to stocks and bonds.
Low costs – ETFs typically have a low expense ratio when compared to actively managed mutual funds. However, there are hidden fees with ETFs you need to consider. Investors typically have to pay a brokerage commission when buying or selling an ETF. If you trade an ETF frequently, you will generate more commission costs. Also, if you are trading a small account, commission charges could be costly. For example, a $20 commission on a $2,000 portfolio is a cost or loss of one percent.
Bid-ask spread – ETF trades also have a bid-ask spread built into the price. The bid-ask spread is the difference between the buy and sell cost of the ETF. This spread can be thought of as a transaction cost paid by the investor. For small or illiquid ETFs, this spread can be substantial and cut deeply into an investor’s returns.
Why choose mutual funds
When our research team conducts a search to find the right investments within a particular asset class, our team includes ETFs in the universe of potential investments. After carefully researching all possible options, we most often conclude that an ETF tends not to be the best investment option within an asset class. We are consistently able to find actively-managed mutual funds that have outperformed their relevant market benchmarks, even when taking fees into consideration. We consider long-term historical performance in our manager selection process though we're cognizant that past results do not guarantee future returns.
There are thousands of mutual funds available to investors, and the majority of these mutual funds do not outperform their benchmarks. Because of this, we have an investment research team dedicated to making informed and careful decisions in an effort to avoid such funds when possible.
What to do next
- Do your own research on the pros and cons of ETFs and other investment funds.
- Make sure all investments fit into your overall financial plan and goals as you build your portfolio.
- Contact an investment advisor with your questions.