Exchange traded funds (or ETFs) are a great to way invest in the stock market, especially for first-time investors. Similar to a mutual fund, an ETF is a collection of investments such as stocks, bonds, commodities or real estate. ETFs can be purchased through investment companies and brokerage houses, and they are quickly gaining popularity because they hold a few key advantages over mutual funds such as tax efficiency, low expenses and flexibility.
Tax Efficiency of Exchange Traded Funds
ETFs minimize tax implications for investors because they offer very low turnover rates compared to mutual funds. “Turnover” represents how much of a fund’s holdings are changed over the course of a year through buying and selling. Why is high turnover considered a bad thing? Because each time a holding is bought or sold within a fund there are taxes, commissions and transaction costs that are passed on to investors. The low turnover and better tax efficiency provided by ETFs make them excellent investments for both retirement and non-retirement accounts.
Low Expenses of Exchange Traded Funds
The cost of running an ETF or mutual fund is passed on to investors by means of the expense ratio. The expense ratio represents the percent of a fund’s assets that go towards paying for the fund to be managed. Some of the costs that are included in the expense ratio are investment advisor fees, administrative costs and marketing fees. A typical expense ratio for a mutual fund may be 1.5%, which means an investor’s total return will be reduced by 1.5% through the course of a year to pay for management fees. In today’s market, investors can’t afford to sacrifice part of their return to pay these high mutual fund expenses. ETFs are a great alternative because the expenses associated with running them are considerably lower than those of running a mutual fund. This is because ETFs use indexing strategies instead of individual stock selection and require less active management.
Flexibility of Exchange Traded Funds
ETFs provide flexibility because they allow investors to easily diversify and buy into any sector, index or asset class they prefer. Investors have the ability to purchase ETFs that invest in a broad stock market index like the S&P 1500, as well as those that invest in niche segments of the economy like the semiconductor and telecom sectors. If there’s a segment of our world’s economy you would like to invest in, there’s an ETF that will let you do it.
Beware of Transaction Costs of Exchange Traded Funds
Each time you buy or sell an ETF you have to pay a transaction cost. The cost will vary depending on which investment company you use and ranges from about $10 to $50 per transaction. The charge is a flat rate regardless of how much you invest, which means ETFs are not good candidates for dollar cost averaging, and you should only consider purchasing them if you have at least $1,000 to invest in each fund. Otherwise the transaction costs will overshadow the low expense ratio. Because there is also a transaction cost when you sell an ETF, you should view these funds as “buy and hold” investments and be willing to keep them for the long term.