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.

2. Cost-Effectiveness

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!

3. Taxes

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.

4. Derivatives

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.

5. Flexibility

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.

6. Accountability

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.

8. Dividends

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).

9. Simplicity

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.

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Author: Stan Poores

I'm a 35 year old engineer from Texas who loves talking about finance.

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7 Comments

  1. All great points regarding ETFs. I love investing in them due to the lack of minimum initial investment that mutual funds require. The interesting thing about them though is that they came about to encourage more trading. Mutual funds can only be transacted on at the close of business whereas ETFs can be traded throughout the day. All those “extra” trades equal fees and commissions for traders. Ideally, investors should look for no fee ETFs – there are tons out there – and keep the trading to minimum.
    Jon @ MoneySmartGuides recently posted..How to Sell a House FastMy Profile

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  2. I exclusively use index mutual funds with Vanguard. No commissions, automatic dividend reinvestment, same fees as the ETFs, easy purchase of partial shares. With those things being equal, the main advantage of an ETF comes from intraday trading, which is really irrelevant for us. I do agree that ETFs can provide advantages in many circumstances, just not in ours.
    Matt Becker recently posted..Carnival of Financial PlanningMy Profile

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  3. I have a mix of mutual funds and individual stocks that I trade on my own but I don’t own and ETF’s. Never took the time to learn more about them so I didn’t want to put money in something I had little knowledge of. I will have to do more research and see if the can fit and work for me just as I did with p2p lending.
    Thomas | Your Daily Finance recently posted..Paying For College with Federal Student LoansMy Profile

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  4. I just have stocks, which I trade on my own and find easy to manage

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  5. The rule of thumb in any investment vehicle is to not engage in any when you do not understand it well. This article is nice intro to ETFs.

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  6. Great points on how ETF’s work. I love the felxibility they offer and I didn’t fully know how the taxes are computed compared to index funds. Thanks for the post.
    Rich Uncle EL recently posted..Life is a BeachMy Profile

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