9 Advantages of ETFs
Exchange traded funds, otherwise known as ETFs, are the perfect addition to any portfolio that you wish to be more diversified, hedged, or more exposed to a specific industry. Sometimes it makes me wonder why people use mutual funds when ETFs seem to hold all of the advantages.
Here are a few of my favorite reasons to use ETFs:
1. Single Transactions
ETFs behave much like an index and are tied to specific market sectors. However, an ETF is like a small portfolio in and of itself as opposed to a basket of stocks. This allows for instant diversification of your money in a single transaction.
Commissions on ETFs are almost always lower than on that of an index fund. Because an index fund is a basket of stocks it requires at least a few trades internally, which can quickly add up in terms of management expenses (generally, though, mutual fund management expenses for index funds are very low, too). Additionally, load fees are nonexistent. Ask your brokerage company if they offer commission-free ETF trades. You might be surprised to find out that they do!
On a mutual fund, the potential for a a capital gains tax tends to be much higher than for an ETF. Taxes on index funds and mutual funds are recognized as soon as the capital gain is earned internally. Even if you purchase an index fund this year, you may end up paying taxes on holdings inside the fund that didn’t make any money while you held the position. On the other hand, an exchange traded fund is considered to be tax friendly as capital gains are not recognized until the investment is sold off.
When an investor needs to hedge their portfolio again risks, ETFs are great tools to do so. Options as well as futures contracts are offered against exchange traded funds, which can help a seasoned investor protect their downside.
ETFs are considered to be flexible because they can be sold on margin and prices trade all day in real time while the market is in session. In the stock market, ETFs and equities are very similar in the way that they behave when transacting. Mutual funds, on the other hand, trade once per day. Therefore, it’s impossible to use stop losses or option tools and if you call to sell your fund at 11 AM, it’ll sell as soon as the market closes.
Much like the way the price is live with an ETF, an ETF is also very transparent in presenting the list of assets that make up the fund. Results are updated each day and investors can see exactly what investments are inside of the ETF. This is rare or nonexistent with many actively traded mutual funds, which purchase unpopular positions but then “window dress” the portfolio when the prospectus is updated.
7. Passive Management
Part of the reason that fees are so low with ETFs is because they are (nearly always) passively managed. They are meant to follow an index, so active management is not crucial to their performance. Some new ETFs are actively managed, and as you’d expect, come laden with higher fees and different risks than the older, more traditional ETFs.
Dividends are paid on many ETFs, and they can be reinvested into the account. Some mutual funds have sporadic and unclear timelines for when dividends will be reinvested. Despite the fact that many pay dividends, ETFs are generally considered tax-friendly (see above).
If you are new to investing or are looking to break into a new industry, ETFs are a great stepping stone for doing so. They are structurally easy to comprehend and the risk associated with many ETFs is relatively low when compared with individual investments such as a stock or a single bond. As is the case with any investment though, it is always a good idea to thoroughly research which ETFs best meet your demands and check out fees and past performance before backing one with actual money.
For anyone hoping to add a little edge to their portfolio, ETFs are a great tool to consider. Regardless of how an investor falls in terms of experience, they are a great addition to nearly any portfolio.