Manage Your Monies

What is an ETF – The Pros & Cons of ETFs

Manage Your Monies

Exchange-traded funds (known as ETFs) are growing in popularity, and there are thousands of ETFs available. As they’re growing in popularity, many are asking, what is an ETF?

ETFs are one of the most valuable products for everyday investors. They give you the ability to invest in a broad array of stock and bonds, while paying a fraction in fees. Some companies even offer free ETFs.

What is an ETF?

ETFs are a basket of securities that you can buy or sell through brokerage firms on a stock exchange. They are offered in any conceivable asset class – from traditional investments like stocks and bonds, to alternative assets like currencies and commodities. There are even ETFs that short the market (betting on a downturn), use leverage, and avoid short-term capital gains taxes.

Previously, individuals had to invest in mutual funds to secure a diverse portfolio of companies. These mutual funds charge a fortune in fees, and make a huge dent in your net worth over time.

There are now over $1 trillion dollars invested in ETFs. As more money is shifting to them, people are saving a fortune compared to what they used to pay for mutual funds.

Types of ETFs

With thousands of ETFs being offered, the options are endless. Any asset class you can imagine has been packaged into an ETF.

How to Buy ETFs

Buying an ETF is the same as buying an individual stock. Simply go to your brokerage account, type in the ticker symbol of the ETF, and decide the purchase price you would like to pay.

For example, if you wanted to buy Vanguard’s S&P 500 ETF. Enter their ticker VOO, and the price you would like to pay for a limit order. Otherwise, you can choose a market order and pay whatever price your brokerage secures the shares for.

Many of your brokerages will offer their ETFs for no trading costs. Vanguard, for example, allows you to buy and sell their ETFs for free. Fidelity also allows this with their ETFs.

You can own an ETF in seconds, which will give you instant access to a diverse portfolio of assets, and you can do it with as little as a couple hundred dollars.

Advantages of ETFs

Now that you know what is an ETF, it is important to keep in mind their advantages. The most important advantage is their cost savings over mutual funds.

Cost Savings of ETFs

ETFs save you a ton of money compared to mutual funds. We previously wrote about how mutual funds are a rip-off, and we’ll show just how dramatic that difference is over time.

The average expense ratios for ETFs are .08%, whereas mutual funds charge 1.25%. Since the average return of the stock market is around 10%, mutual funds are charging 12.5% of your overall returns!

If you invest $10,000 over 30 years, the fees from mutual funds will cost you over $50,000.

Tax Savings of ETFs

ETFs also offer a considerable tax savings compared to mutual funds. When investors exit a mutual fund, the mutual fund needs to sell shares of stock to pay them back. Doing so harms the return of the fund’s investors.

For ETFs, capital gains are only considered when an investor sells their share. Therefore, only that individual has to pay capital gains, and the rest of the investors are protected from this.

Buy & Sell Throughout the Day

ETFs are traded through the stock market, and can be bought and sold any time throughout the day. Mutual funds, however, are settled when the market closes.

Disadvantages of ETFs

While we strongly encourage ETFs over mutual funds, they are some drawbacks to keep in mind.

Trading Costs

Since mutual funds are bought and sold like stocks, there may be trading costs associated with them. Many brokerages offer their ETFs for free, but we recommend comparing expense ratios instead of just blindly buying what’s “free”.

For example, if you’re investing $1,000 in an ETF that costs $5 in transaction fees and an expense ratio of .04%, you will end up paying $5.40 for the first year. This is $5 in transaction fees, and 40 cents in annual fees (.04% * $1,000).

If you instead invested in an ETF with a 1% expense ratio and “free” transaction costs. You’ll end up paying $10 in annual fees, nearly twice the cost of the one that wasn’t free!

Tracking Errors

While ETFs are designed to track certain asset classes or markets, they will not track it perfectly. We recommend reading reviews of ETFs, and comparing them to how they historically track their asset class.

For example, if you’re looking at an S&P 500 ETF, chart the return of the ETF compared to the actual S&P 500 for the last 5 years. The more identical they are, the more similar their returns should be in the future.

Settlement Dates

Similar to stocks, ETFs take 2 days to settle a transaction. Therefore, you technically will not have access to these funds for 2 days.

This is generally only an issue if you need to withdraw the cash. Many brokerages will allow you to reinvest the money immediately without waiting for 2 days.

Liquidity

Some ETFs may not be actively traded, which will give them a high bid/ask spread. The higher this spread, the more you pay as a buyer, and the less you’ll receive as a seller.

What is an ETF – The Bottom Line

There are now over $1 trillion in exchange-traded funds, and there are trillions more that should move from mutual funds to ETFs. ETFs cost a fraction of the price of mutual funds, while offering their investors a tax savings, and can be bought and sold in real time just like a stock.

While there are some drawbacks, the pros far outweigh the cons. Even Warren Buffett says that a low cost S&P 500 ETF is the best option for most investors.

With only a couple hundred dollars, you can become an ETF owner today. Do your research, and enjoy the life of being a diversified investor that is saving a ton of money.