The topic of ETFs will come up fairly quickly when someone is seeking investment advice. ETFs, or Exchange Traded Funds, are a simple way to diversify a small investment while at the same time getting the most out of it. Before you dive in, it is important to understand how ETFs operate.
ETFs are a lot like mutual funds, in that they are a collection of investments — but they are traded on an exchange like the NYSE, instead of being directly purchased from the issuing company. ETFs also differ in redemption structure and tax efficiency from traditional mutual funds.
Here are some great benefits of investing in ETFs over mutual funds.
- Tax Efficiency: When redeeming mutual funds they must sell their underlying securities, which make the capital gains available for distribution to the owners of the funds. Since ETFs trade on an exchange and investors are selling to other investors, no underlying securities are sold and no capital gains are distributed. If the makeup of the ETF changes it will occasionally have to distribute gains, but it should be much less frequent than it would be with traditional mutual funds.
- Lower Fees: Exchange Traded Funds are “no-load funds,” and you won’t be hit with a redemption fee when it’s time to liquidate your position. Furthermore, ETFs typically have lower annual fees than traditional mutual funds, which make them a very attractive alternative. (NOTE: In rare cases where a very small amount is being traded, broker’s fees may be a higher percentage of the investment than a mutual fund’s expenses would be, but in most of these cases the invested amount would not meet the minimum investment required by most mutual funds).
- Liquidity: The exchange-traded structure of ETFs generally allow for liquidation of a position faster than a mutual fund, which must be liquidated at end of day. The ability to set a limit order also allows for flexible trading that no investor would be able to get from a mutual fund. However, not all ETFs have the same liquidity and it is important that you review trading volumes with your financial analyst and the ETF prospectus to determine whether you are comfortable with the frequency of trades.
- Intraday Pricing: Purchases and sells happen at market prices because ETFs are traded on active stock exchanges. This happens rather than end-of-day Net Asset Value, which is what mutual funds use. With that being said, someone can purchase ETFs at a premium or discount to the value of the underlying asset.
- No Minimum Investment: When you start investing oftentimes you will find that diversification will be very expensive or “cost prohibitive.” This is especially the case when you are using mutual funds. While mutual funds are low risk, they traditionally have a minimum investment requirement of $2,500 or more. Since ETFs have no minimum investment (other than the market price of one share), they are a good vehicle for diversified investing.
Remember, even though there are a number of great benefits involved with investing in ETFs, these benefits could still be liabilities if not used and/or handled properly. Again, make sure you have a professional helping you out with your portfolio and guiding you on the right path.
If used properly ETFs can be a great vehicle to widely diversify a small initial investment.