The Beauty of ETFs

Beloved, I pray that you may prosper in all things and be in health, just as your soul prospers. (3 John 1:2 World English Bible)

Are exchange-traded funds a better choice than mutual funds? Let’s take a close look.

Exchange traded funds (ETFs) are pools of money which track indexes like the S&P 500, NASDAQ 100, and Russell 2000.

When you buy shares of an ETF, you are buying shares of a diversified portfolio, which tracks the total overall return of its index.

ETFs are traded like a stock on all three major stock exchanges. You can trade an ETF any time the stock markets are open, and you can do it in real time. A mutual fund, on the other hand, gets bought or sold at the close of business each trading day. Why might that be important? Suppose we encounter another event like 9/11. Would you want to sell your investments immediately or at the end of the trading day, after a severe market decline.

The ETF industry started 25 years ago. They have since become one of the most popular investment vehicles, with over one-trillion dollars under management.

Like mutual funds, there are various types of exchange-traded funds. You can choose from stock, bond, international and sector ETFs.

The beauty of ETFs is that they have far more benefits than MFs, like tax efficiency, for instance. According to Fidelity.com, ETFs have major tax advantages compared to mutual funds. Due to structural differences, mutual funds typically incur more capital gains taxes than ETFs.

Moreover, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor, whereas mutual funds pass on capital gains taxes to investors through the life of the investment. In short, ETFs have lower capital gains, and they are payable only upon the sale of the ETF.

Capital gains in a typical stock mutual fund can be between 5 to 6% per year compared to less than 1% in an ETF. Another benefit is cost-efficiency. Because ETFs track an index and is not actively managed like most mutual funds, ETF fees can be substantially lower. No manager to pay, no commissions or front-end loads to pay, and, with virtually no trading costs, your annual savings is somewhere around 0.75%-1%.

I cannot overemphasize how important 1% per year is to your financial well-being over the long term. You end up wasting tens of thousands of dollars in a $100,00 portfolio and hundreds of thousands in a million-dollar nest egg over a 25-year period.

Exchange traded funds are not for everyone, however. Buying small dollar amounts on a continuous basis does not make sense. Why? Because you’ll need to open a brokerage account in order to purchase an ETF and therefore, pay a commission (I pay $4.95) each time you buy or sell.

As long as you plan on making a larger ($5,000 or more) lump sum investment and plan on holding on for the long term, paying a one-time commission of five dollars is reasonable.

Okay, let’s recap. Why an exchange traded fund instead of a mutual fund?

Fees matter. So do taxes, trading costs, and commissions.

Most knowledgeable investors agree the pluses of ETFs overshadow those of a MF by a sizable margin. To be a great investor, you must invest wisely. A wise investor keeps her eyes on fees, charges, and expenses.

Focus on what matters.

Listen to my podcast on ETFs and mutual funds on greatinvestor.org if you want to learn more.

And please like and share our Facebook page.

Thanks and Blessings!