What Is An Exchange Traded Fund (ETF)? What Are The Benefits? Should I Consider Using One?

When it comes to becoming a beginning investor, one thing that can hold a lot of people back is the fact that starting to invest can feel like it’s so confusing, with so many options out there, diffferent types of investments and investment classes.  Where should you start?  Should you hold mutual funds only? Index funds?  What about ETFs?

As part of my continuing efforts to educate myself as to what the different options out there are I’ve recently been reading up on a class of investments that are relatively recent innovations – the Exchange Traded Fund.

What exactly is an ETF?   It’s basically the investing world lovechild of a mutual fund and an individual stock where you have the diversification of a mutual fund, but also the ability to trade the investment like a stock on a stock exchange.

What Is An ETF?

Exchange Traded Funds have been around since the early 1993.   In January 1993 the first ETF was launched, the Standard & Poor’s Depository Receipts (SPDR) ETF.  The ETF basically was setup to track the performance of the S&P 500 index.  In 1995 S&P introduced a second mid-cap ETF, and after that other companies began launching a number of ETFs to track avariety of different exchanges/indexes and asset classes.

So in it’s most basic form, what is an ETF? An ETF looks a lot like a mutual fund in that it holds a variety of investments for you, but it can also  trade like a stock on the stock exchange.  ETFs allow the individual investor to diversify their holdings while still giving them the flexibility to be able to trade during the day, unlike a mutual fund.

Most ETFs are set up to track a given index like the S&P 500, so they would be classified for the  most part as passive investments – since most of them are not actively managed.  Because they are relatively passive in nature they also tend to have lower costs than some other investment options.

Reasons To Use An ETF

There are  a variety of reasons why you may want to invest in ETFs.

• Low cost:  ETFs in general are going to have lower costs than some other investment products because most aren’t actively managed, and because ETFs don’t have to sell securities to accomodate shareholder purchases and redemptions.  They also typtically have lower marketing and other fees.
• Flexibility for buying and selling: ETFs can be bought or sold at any time during the trading day at whatever the current market price is.  By comparison mutual funds can only be traded at the end of the trading day.   Also, since they are publicly traded securities, more advanced investment strategies like hedging strategies, stop and limit orders and purchasing on margin and short selling can be done.
• Tax efficiency:  ETFs in general will usually have lower capital gains because of low securities turnover in their portfolios.  They also don’t have to sell securities to meet investor redemptions, which further enhances tax efficiency.
• Diversification exposure to different markets: Like index funds most ETFs will provide instant diversification across an entire index, while still giving you access to a variety of different industry specific and commodity ETFs that aren’t available easily elsewhere.

So as you can see there are a good number of reasons why to consider ETFs for your portfolio.  There are also things to be wary of including the fact that you’ll have to pay brokerage fees every time you purchase or trade your ETFs.

Which Is A Better Option For Me: Index Fund Or ETF?

So since ETFs and indexed mutual funds are so similar in that they’re both usually tracking the performance of a given market or exchange, which one should you consider adding to your portfolio?

Mike over at ObliviousInvestor.com breaks it down in a post on ETFs vs. Index Funds, and gives the answer of “it depends”.

In summary,

• the longer your time horizon,
• the greater the amount you’re investing, and
• the greater the difference between the expense ratios,

…the more sense it makes to use ETFs.

It really is going to depend on a variety of factors, including how long you’re investing for, how much you’re planning on investing, the expense ratios for the funds vs ETF, as well as how often you plan on rebalancing your portfolio as ETFs will usually carry brokerage fees/etc for rebalancing and/or purchasing new shares.

Conclusion

Exchange Traded Funds can be a great idea for the average investor, especially for those who want a few more investment options when it comes to commodities and the like.  The fact that they have low costs, are tax efficient and that they can give you some great diversification while allowing you to do some more traditional trading strategies all mean that the ETF will be popular for years to come.

For a more in depth look at ETFs, check out the tutorial linked below, or to find a brokerage where you can open an account and buy ETFs, check out our list of discount brokerages.

• Introduction To ETFs on Investopedia

Are you currently investing with or using an ETF?  Why are you using an ETF as part of your investing strategy?  Are you avoiding ETFs for any reason?  Tell us your thoughts on Exchange Traded Funds in the comments.