If you are a long-term investor looking to buy and hold, looking to build a portfolio, exchange-traded funds (ETFs) are worth it. They have a number of advantages over mutual funds, and you can buy ETFs that are focused on just about any market you can think of.
However, before investing, it is important to understand ETFs. Learn how they differ from mutual funds and research their advantages and disadvantages relative to conventional mutual funds.
What is an ETF?
Open End Mutual Funds vs. End Closed
As you may already understand, a mutual fund is an arrangement in which investors pool their money and hire a portfolio manager to buy and sell securities on their behalf. With traditional mutual funds, investors can buy or sell shares directly from the fund company itself. However, closed-fund shares are traded on exchanges as if they were stocks, and are typically purchased from other shareholders.
Unless the fund company is buying shares or selling foundational shares to its initial subscribers, the fund company itself is not involved in secondary market transactions. However, as with variable capital mutual funds, you still have a fund manager (or a team of managers) trying to buy and sell securities on behalf of shareholders.
One key difference: When you buy open funds, your counterpart (who you buy from) is always the same fund company. They will buy or sell shares at their net asset value (NAV) from the market close at the end of the day. If you buy them after the markets open, you get the closing price of the fund for that business day. If you buy them after the markets close for the day, you get the price at the close of the next business day.
With closed funds and exchange-traded funds, on the other hand, your counterpart is typically not the fund company itself, but rather other shareholders who buy or sell shares around the clock, either directly or, more commonly, on exchanges of values. You can buy and sell stocks at any price a willing buyer or seller can find.
ETFs and closed funds
ETFs are close cousins to closed funds. Like closed fund stocks, ETF stocks can be bought and sold on exchanges, just like any other stocks. The main difference is that ETFs are not actively managed. Instead, the securities in an ETF portfolio are simply a basket of securities designed to replicate an index as closely as possible.
For example, an S&P 500 index fund owns stocks in companies included in the Standard & Poor’s 500 list of the largest companies listed on the New York Stock Exchange, as detailed by market capitalization. You can buy stocks in an open S&P 500 fund, such as the Vanguard 500, or you can buy the ETF version, also called SPDR (“spider”). Think of ETFs as closed index funds, traded on stock exchanges.
Advantages of ETFs
Since ETF shareholders do not need to pay a manager and a team of analysts and brokers to buy and sell funds on their behalf, or to manage fund inflows and outflows, exchange traded funds typically have a ratio of Much lower expenses than traditional mutual funds. Their expense ratios also tend to be lower than open index funds, as even open index funds have to have enough staff on hand to process ongoing purchases and repayments.
For example, many large-cap mutual funds charge expense ratios of 80 basis points, or 0.8% per year or more. Investor shares in open mutual funds generally have an expense ratio of 18 to 50 basis points, depending on the index. Investor stocks in large-cap index funds, such as S&P 500 index funds, will typically charge between 18 and 20 basis points. But the large-cap ETF can charge 10-15 basis points continuously.
However, you also need to consider the cost of the negotiation. When you buy or sell an ETF or a closed fund, you will generally need to pay a commission to a broker, although some low-cost online brokerage agencies have commission charges as low as $ 4 per trade. With open funds, you may also be charged an additional sales charge, typically between 5.85% and 6.2% for “Class A” shares if you go through a full service broker or financial advisor.That said, you can also buy shares in a mutual fund “no load” directly from the fund company without paying a commission.
When you buy an open mutual fund, you can only buy shares in the fund once per day, at their net asset value as of the last market close. You can’t buy or sell stocks during the day – If you own an open fund and hear disastrous news in the morning after the markets open, you can’t sell until after 4pm EST that afternoon. Similarly, you cannot buy good news. All purchases are not posted until after 4pm the next day.
ETFs and closed mutual funds can be sold around the clock on stock exchanges, although some funds are traded more frequently than others. The more frequently the fund is traded, the easier it is to find a buyer or seller willing to do so quickly.3. Short Selling
With open funds, you cannot engage in short selling, the practice of borrowing stocks and selling them with the expectation that stock prices will fall. If prices drop, the short seller buys the shares at the new price and returns them to the original owner, keeping the difference. However, you can narrow down entire industries, countries, and markets by using ETF stocks.
4. Tax Considerations and Low Staff Turnover
Index funds, including ETFs, tend to be very tax efficient and ideal for holding in taxable accounts. This is because portfolio turnover in index funds is very low, while managed fund managers actively sell securities and buy new ones whenever they have a better investment idea. Index funds and ETFs, on the other hand, only sell stocks when new stocks are removed from the index and buy stocks only when they are added to the index.
Every time a fund sells a stock at a profit, the IRS assesses capital gains tax, which is passed on to shareholders. Since index funds and ETFs don’t sell stocks very often, they rarely generate a taxable distribution for their shareholders.
5. Lack of redemptions
ETFs are generally a bit more tax efficient than open index funds, because ETFs don’t have to worry about selling stocks to meet redemptions. That function is served by the open market; ETF staff are out of the picture.
6. In-kind distributions
ETFs also have the option of making an “in-kind” distribution to shareholders. This means that they can send portfolio securities directly to shareholders and let them sell them themselves if they want the cash. This helps protect the remaining shareholders of the fund from the tax consequences of the sale.
However, if the ETF portfolio generates dividend income, this income is taxable, as is the case with closed and open mutual funds.7.
Cashless Index fund portfolios try to track an index as closely as possible. As a result, they typically have very little cash in their wallets. They are 100% fully invested at all times. This works to your advantage in rising markets. ETFs don’t care about meeting repayments, so they can afford to have almost no cash on hand. However, in declining markets, a low cash position hurts the fund – the portfolio bears most of the market downturn.