Thursday, 03 July 2014 08:57 Last Updated on Thursday, 03 July 2014 09:18
Your Money Matters, June 22, 2014
In recent columns, my goal has been to give an overview of some of the most common investment vehicles you encounter when investing. We've looked at mutual funds and their various flavors, closed end funds, and this time we'll take on one that's quickly gaining popularity — exchange traded funds.
Exchange traded funds, or ETFs as they are commonly called, are very similar to mutual funds in that they are a vehicle designed to provide a investors a level of diversification that would be difficult to achieve by investing in a basket of stocks on their own.
ETF's, like mutual funds, pool investors' money together to purchase many stocks or bonds, perhaps hundreds or even thousands, according to its stated objective. To invest on your own in a way that matches "the market," the S&P 500 index, you would need to purchase stock in all 500 companies from the index. That's quite a bit of money and management. Instead, with a mutual fund or ETF that tracks that index, you can invest a much smaller amount of money and still be spread across the same stocks.
So what is the difference between a mutual fund and an ETF? The most obvious difference between the two is how they trade. When you buy or sell a mutual fund, regardless of when you put the order in, your trade will be processed after 4 p.m. when the markets close. That is because the price of the fund for that day (the net asset value, or NAV) is determined based on the closing price of all the stocks or bonds that comprise the fund.
An ETF on the other hand, trades all day long, like a stock. That means the price fluctuates throughout the day, based on the prices of the investments it holds as well as the supply and demand of the ETF itself. While in most cases the price does not stray too far from the value of the investments it holds, it can cause a problem if you invest in an ETF that does not have a lot of trading volume.
If you are looking to sell your ETF and there are few buyers out there, as there may be for a newer one or a specialized fund, you may find yourself in a position to be selling for less than the value, since you are selling essentially to another individual buyer. Mutual funds, on the other hand, must have enough liquidity to redeem your shares for the asset value whenever you want to sell.
Since ETFs are available for trade during the day, they are listed on the stock exchange, and you can follow their prices up and down as you might a stock. Buy and sell transactions are handled similarly. ETFs don't have the sales loads (sales commissions) that some mutual funds do, although there are plenty of no-load mutual funds available on the market, too. Although there is no sales commission, depending on where you are buying and selling, you may pay a broker's trade commission or fee.
Trading a mutual fund may cost more or less than trading an ETF, depending on what fund you are buying and if it is on the brokerage company's no-transaction fee list or not. For instance, at a discount brokerage, you may pay $7 for an ETF trade, $17 for a mutual fund that has a transaction fee, or zero for a no-transaction fee mutual fund.
Just like mutual funds, ETFs have ongoing operating costs, which vary from fund to fund. The original ETF market consisted mainly of funds that tracked indexes passively, which kept costs down, just like an index mutual fund that holds only the investments of specified indices like the S&P 500. But you can buy an active ETF — an ETF that is run by a fund manager or management team — with the goal of beating their benchmark through buying and selling investments. The cost differential can be wide. For example, the iShares Core S&P 500 (IVV) carries expenses of 0.07 percent, while PowerShares Dynamic Market's (PWC) is 0.60 percent.
Now, 0.60 percent is a far cry from the more than 2 percent expense ratios I've seen in some (ugly) actively managed mutual funds, but it is quite a bit higher than 0.07 percent. These funds have different objectives and are not apples to apples comparisons, so don't take that to mean that one is necessarily better than the other; it simply illustrates the point that fees can vary and should be taken into consideration when evaluating a fund.
When looking for an ETF for your investments, just like when choosing a mutual fund, start with personal objectives — factors like what are you investing for, what is your time horizon, what kind of risk do you want and can afford to take and then what allocation between stocks, bonds or other investments (and what types within those categories) are appropriate for you — before deciding how to meet those objectives.
Mutual funds, ETFs, individual stocks or bonds, all are tools you can pick from, but they are not the objective themselves. Always start with why you are investing and what you are trying to accomplish before moving on to the how to do it. Be sure any adviser you may work with does the same.