An Exchange-traded fund (ETF) is essentially a mutual fund that is traded like a stock. The ETF is composed of a basket of securities. Its value is usually equal to, or very close to, the net value of the underlying assets contained within. But are these a wise investment choice? Let’s take a closer look at some of the advantages that ETFs have to offer investors.
Keep Costs Down
When an investor is trading in individual stocks, it is very difficult to beat the market, especially once you factor in the fees that are involved. An ETF won’t magically allow you to trade and invest without risk, but it will allow you to at least match the market.
Advantages Over Stocks
In some ways, the advantages that an ETF offers are the same as those offered by mutual funds when it comes to picking individual stocks. This advantage can be summed up in a single word – diversification. Diversification is one of the most powerful tools in an investor’s arsenal and one of the most effective ways of reducing risk without impacting returns.
Let’s say that you have made the decision to invest in a particular sector. You could try your hand at picking some individual stocks to invest in and hope that these do well. However, a better and less risky strategy would be to buy an index-linked ETF. This shields you from many of the effects of market volatility and allows you to reduce your trade to a single transaction.
Advantages Over Mutual Funds
Because most ETFs are indexed, there is a level of certainty regarding their performance. Usually, they will outperform actively-managed mutual funds and represent a safer investment in a number of regards.
For example, on average the expense ratios are much lower on an ETF (0.25 – 0.75%) than they are on an actively-managed mutual (around 2%). Additionally, mutual funds will often have a minimum investment bar which can run into the thousands of dollars. This barrier does not exist with an ETF, which can be bought or sold in increments of just a single share.
An actively-managed mutual fund will be subject to a much greater turnover than an ETF. This, in turn, incurs more taxes. With an ETF, the distribution of tax gains is much more frequent.
Another big selling point of the ETF over a mutual fund is that mutual funds are priced only once every day, at the close of market. By contrast, the price of an ETF changes throughout the day and can be bought or sold at any time. See this guide to ETF vs mutual fund for more information.
The Advantage over Index Funds
With much lower expense ratios than mutual funds, index funds can keep your costs too. An index fund represents another very reasonable way to invest in a market while keeping trading costs down. However, many investors still feel that the ETF edges out the index fund as an investment tool. ETFs have no minimum investment limits and can be traded intra-day, two features still missing from index funds.
Despite being relatively new to the financial world, ETFs are proving themselves to be a popular and effective investment tool.