Gardner: Investing in ETFs (column)
Chris writes: I have been following your column and reading your new topic on investments with special interest. Investing is an area I just don’t understand and know I should if I am going to be able to really save money for the future. I appreciate the explanation of mutual funds but am wondering what the difference is between them and ETFs. What are ETFs and when should they be used?
That is a great question Chris and I am glad you asked. ETFs, short for exchange traded funds, are like mutual funds in that they are investment companies whose shares trade on stock exchanges. Unlike mutual funds, ETF shares can be purchased and sold throughout the business day of the markets. ETFs are usually structured like an index fund that is created to mimic the performance of a particular market segment such as technology or financials. The index owns all or a representative sample of company stocks in the targeted segment. Mutual funds are the number one investment choice for individual investors, but ETFs have become an increasingly popular alternative to mutual funds. Their numbers and the amount invested in them are growing exponentially. Approximately 8 percent of individual investors that own mutual funds also own ETFs. They have become particularly popular with institutional investors who use them as a hedge against broad market movements.
So why do investors like ETFs? Diversification is one of the primary reasons for investing in ETFs, as well as mutual funds. You can greatly minimize your risk by investing in different types of securities and numerous companies with a minimal cash investment. For as little as $500 or $1,000 you can get started. That brings us to the convenience. You can open an account easily at any of the discount brokerage houses, either in person or online. Professional management of ETFs and mutual funds does have a fee associated with it, but it does allow investors to not worry about their portfolios on a daily basis. In addition, the returns are generally better than the average individual investor is able to achieve. Most ETFs are passively managed, which brings down management fees and there are low costs overall. As an added benefit of passive management, there is lower portfolio turnover and low taxes on gains. Capital gains are rarely distributed to shareholders by these ETFs, and that keeps the fund’s tax liability low.
Actively managed ETFs will probably have higher costs, portfolio turnover and taxes, so you will want to understand how any ETFs are managed before investing. These funds cover a wide array of domestic and international stock indexes as well as corporate bond indexes from which to choose.
Some of my favorite reasons to invest in ETFs are diversification and low fees, but what I like best is that they trade like individual stocks. You can pick your price to buy or sell throughout the day. With mutual funds you do not find out until the day’s end settlement.
Nancy Gardner is a Certified Financial Planner. She and her husband Bill split their time between Summit County and Montgomery County, Texas. Send questions to Nancygardner2016@yahoo.com.
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