Exchange Traded Funds Offer Key Advantages Over Mutual Funds
Exchange traded funds (ETF) have become an increasingly popular way for investors to play the stock, bond and commodities markets without dealing with individuals stocks, bonds or mutual funds.
ETFs are often compared with mutual funds because they both enable investors to buy into a broad basket of stocks or other types of investments with a single purchase. However, while most stock mutual funds are actively managed by a portfolio manager, most ETFs are set up merely to track a particular index, such as the Standard & Poor’s 500, the Dow Jones Industrial Average, the Russell 2000, or a more specific international or sector index.
Until the rules were changed in 2008, ETFs were all index-type funds that were not actively managed. Since 2008 a few managed ETFs have been launched, but the majority of ETFs are still tied to an index.
Why are so many investors and money managers switching to ETFs in place of mutual funds? ETFs offer some very enticing benefits over mutual funds:
Easier to trade. ETFs trade just like stocks on the major stock exchanges. There are no loads—either front end or back end, as you would face with many mutual. Your only transaction cost is the brokerage fee you’d pay to buy or sell your ETF—the same as it would be to buy or sell a traditional stock. And since most ETFs are not actively managed, the annual management fees you’d pay are relatively inconsequential compared with the typical management fee of a mutual fund, which tends to range from about 0.05 percent (half a percent) to 2 percent of assets under management each year. Management fees for ETFs typically range from just 0.01 percent (one-tenth of one percent) to 0.05 percent (half a percent) of assets under management.
Flexibility. When you sell a mutual fund, you have to wait until trading closes before the transaction is actually made. With an ETF, you can sell at any time during the day. If the market is up 200 points in the morning and you want to take your profit for fear it may drop back down in the afternoon, you can sell an ETF at its current trading value. With a mutual fund, you’d have to take your chances and wait until trading closes before your shares would be sold—at the value posted at the end of the day.
Limit orders. Just as you can do with any stock, you can use a limit order when you buy your ETFs. (A limit order is an order to buy or sell a stock at a set price.) So if you want to buy an ETF at a dollar or two below its current trading price—or sell it at a set price above its current price—you can put in a limit order and the transaction will be completed when or if it hits your target price.
Taxes. ETFs tend to have certain tax benefits over mutual funds. Mutual funds pay out all capital gains at the end of each year, generating a tax liability for shareholders—even those who didn’t buy the fund until near the end of the year. ETF investors are only liable for capital gains earned while they were holding the EFT. Taxable transactions also tend to be less frequent with ETFs since most of them are not actively managed with ongoing trading by the portfolio manager.
ETFs are offered by a growing number of investment companies. Barclays Global Investor has been a pioneer in the ETF market with its wide offering of more than 100 portfolios of what it terms “iShares”. Some of the other leading ETF firms include State Street Global Advisors, Vanguard, PowerShares, and Merrill Lynch.
Investors are able to pursue a wide range of strategies with ETFs.
Day traders and active investors can move in and out of the market and out of their positions more quickly, more easily and more inexpensively than they could with mutual funds. And because they typically hold a broad range of stocks, ETF traders can work with the entire market—or sectors of the market –rather than trading individual stocks.
Long-term investors can build a diversified portfolio of ETFs by investing in broad-based index portfolios of both blue chips and smaller stocks, and add in foreign indexed ETFs or a broad international ETF, as well as ETFs from nearly any sector of the economy.
But you don’t have to stop with stocks. Some ETFs invest in corporate or government bonds—both high yield and standard. You can also use ETFs to diversify into the precious metals or commodities markets. For independent investors who want to manage their own portfolio, ETFs offer an enticing mix of convenience, diversity, and tax benefits
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