Exchange-traded funds (ETFs) have grown in popularity, drawing investors’ interest with low expenses, diversification, trading flexibility and tax efficiency. While there are many advantages to ETFs, like every investment, they have a downside as well. Investors should always educate themselves on the products that make up their portfolios, so here is a guide to what you should know if you’re exploring ETFs.
Overview – Similar to mutual funds, ETFs pool investor funds to buy securities (stocks, bonds or commodities). Unlike mutual funds, which can only be bought or sold at the end of the day, ETFs can be traded throughout the market day like stocks, and can be sold short or with options contracts. Most ETFs are index-style securities made up of investment products that track an index, such as a stock or bond index, and are passively managed by a computer algorithm. A smaller number of ETFs are actively controlled by a manager or a team regarding the fund’s portfolio allocation.
Expenses – One of the main benefits of ETFs are their low management fees or expense ratios. The average ETF has a 0.44% expense ratio, while the average mutual fund fee ranges between 1.3%-1.5%. While it is important to note that the fee differential should be compared on a case-by-case basis, index funds are generally simpler to run than mutual funds since they do not require security selection and can largely be passively managed by software. ETFs’ low fees can be attractive, but investors should keep in mind that because ETFs are traded on an exchange, each transaction is subject to a broker commission, which can vary based upon the brokerage and the purchasing strategy chosen by the customer.
Flexibility – ETFs are traded on an exchange, similar to stocks and bonds, which can be an advantage or a disadvantage depending on your level of investing experience. Unlike a mutual fund, where shareholders can only buy or sell holdings in a fund at the end of the market day, ETFs can be traded throughout an exchange’s hours of operation. With such trading flexibility comes a word of caution: it is important for investors to avoid emotional investing or attempting to time the market. While it may seem tempting to invest in a popular fund or to sell shares of an ETF when its value goes down, trading on emotion can result in purchasing an over-valued fund, or selling an ETF at a lower price than the value of the underlying assets. The best advice for investors is to wait and make sure they are making an informed decision.
Investors should also keep in mind that while they are able to sell their holdings in a mutual fund to redeem their assets, selling an ETF requires another party on the exchange purchasing an investor’s shares. Liquidity risks are low with established ETFs, but this could play a factor in newer, less proven funds. ETFs may provide investors with trading flexibility, but it is crucial to research each investment carefully, looking at factors such as an ETF’s performance, when it was formed and which firm is its sponsor.
Tax efficiency – While ETFs and mutual funds both pool securities in funds, ETFs are structured to be much more tax efficient. When a mutual fund realizes a capital gain, or profits from the sale of a security that is not balanced by a loss, the fund must distribute those gains to its shareholders, which are taxable. By contrast, holders of ETFs typically only realize capital gains when they sell their shares or the ETF conducts trades that reflect trends in the index, giving investors fewer instances where they would have to pay taxes.
Bottom line – While it is important to carefully select the securities that make up a portfolio, investors need to be cognizant that the fees or tax structure of their investment products are not to blame if they are unprepared for retirement. There is no magic bullet or investment pick that will ensure investors are ready for retirement – only a commitment to saving money and managing spending. To navigate the road to retirement, many people work with financial advisors to make sure they are on track for financial stability later in life.
At Summit Financial, we have extensive experience working with both organizations and individual clients to help them assess their retirement readiness and ensure they have the best chance of meeting their retirement goals. If you have interest in learning more about ETFs or other investment matters, please feel free to reach out to Summit for an independent plan review.
Summit Financial Corporation
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Burlington, MA 01803
Tel: (781) 229-9500
Fax: (781) 229-2700
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