CNBC recently published a story on the growing popularity of exchange-traded funds, or ETFs. According to the article, 81% of advisors surveyed said they used or recommended ETFs to their clients in 2015. We have been advocating ETFs as a secure, flexible investment for our clients since the days when they weren’t as popular.
Here’s a look at some ETF basics. (For related reading, see: Why Investors Can Be Their Own Worst Enemy.)
What Are ETFs?
An ETF combines features of stocks and mutual funds. Like a mutual fund, it is composed of a group of stocks, giving investors access to a diverse array of securities with only one transaction, an investment in the fund. And like stocks, an ETF can be bought or sold on the open market at market-determined prices. ETFs are usually used to track specific indexes of the securities market as a whole or of specific sectors. The first ETF in 1993 was created to track and match the performance of the S&P 500 index.
Why Do We Use Them?
ETFs have a number of advantages for investors who are saving for retirement. These include:
- Transparency: While the holdings of a regular mutual fund are only reported every quarter or year, ETFs report their holdings every day since they are traded and the holdings are a reflection of an index. Knowing exactly which positions you are invested in can help with fine-tuning your portfolio according to your risk tolerance.
- Lower costs: The passive nature of ETFs allows them to have significantly lower costs than a mutual fund. In short, actively managed funds, as the name implies, execute a far greater number of trades than passive funds like ETFs, which are generally not overseen by a fund manager on a daily basis. As a result, ETFs usually incur much lower costs than actively managed funds. (For more, see: Don’t Expect to Win With Actively Managed Funds.)
- Flexibility: Mutual funds, whether active or passive, can only be sold at the end of the trading day. On the other hand, ETFs are traded throughout the day and their price continually updated.
- Tax efficiency: There are several factors underlying the structure and operations of ETFs that make them more efficient than a lot of mutual funds. To buy shares of a mutual fund, you must exchange cash for shares directly with the fund. There is no middleman; therefore, when the fund realizes capital gains on an investment, those gains are passed through to the individual investors and you must pay tax on it. When purchasing shares of an ETF, the shares in the ETF are purchased through a middleman called an Authorized Participant, not the fund itself. (The AP purchases shares from the fund when they are originally issued.) This degree of removal from the fund and the capital gains it realizes can help you avoid significant taxes on long-term capital gains. Additionally, since ETFs don’t make as many trades as actively-managed funds, there are fewer chances for an event that could generate capital gains, which will be taxed.
So how do they fit with our investment strategy? We think that your best chance at building wealth through the markets for retirement is to work with a fiduciary advisor to utilize a long-term approach that emphasizes diversification, tax efficiency, risk management and cost effectiveness. We believe in the efficient market hypothesis, which dictates that in the long run, it is nearly impossible to beat the returns of the market by picking individual stocks and market timing. Therefore, an ETF is generally a stable—but flexible—tool for long-term growth if used properly. (For related reading, see: 8 Common Biases That Impact Investment Decisions.)
This article was originally published on Investopedia.com