Walk into your local Wal-Mart and you're sure to come across some product you've never seen before. Maybe a new variation on the food processor, or some technologically advanced electric razor. Just as product designers have a seemingly endless flow of creativity, so do finance companies offering investment instruments. One such instrument is the exchange traded fund (ETF).
In the simplest terms, an ETF can be described as a cross between a mutual fund and a stock. Like mutual funds, ETFs are diversified portfolios of securities that are supported by pooled investor dollars. Like stocks, ETFs trade on the major exchanges, and are continually repriced as transactions happen throughout the day. Mutual funds, on the other hand, are repriced only once daily based on the value of the underlying assets.
Lots to like about ETFs
An ETF can be a busy investor's best friend. It offers:
Passive management, low expense ratios, better returns. ETFs are passively managed, meaning that the underlying assets in the portfolio duplicate the assets of a particular index (like the S&P 500). Relative to actively managed funds that require a manager and research staff, passively managed funds have lower operational expenses. These lower costs flow through to investors as higher returns.
Fewer trades in the underlying assets, lower tax bill. Actively managed mutual funds transact a higher number of trades within the portfolio. When these result in capital gains that aren't offset by losses, the fund must distribute those taxable capital gains to shareholders. ETF investors usually won't incur capital gains taxes until they sell their own shares.
No minimum investment, low-cost diversification, lower risk. Most traditional mutual funds have a minimum investment requirement of a few thousand dollars. ETFs don't have such a requirement. If you can only scrape together enough money to purchase one share of an ETF, you can do that. This isn't to say it's a good idea to buy just one share, but if you did, you'd be getting a diversified investment at a very low buy-in cost.
What's not to like about ETFs?
Broker's fees, lower returns. You don't incur broker's fees with mutual fund transactions; but you will when you buy or sell an ETF. If you're in the practice of investing a small amount of money each month, you're better off with a mutual fund.
If you decide that ETF investing is for you, be conservative and stick with funds that track mainstream indices. Some companies offer extremely specialized sector funds as an alternative, but these are best left to experienced, savvy investors who are pursuing specific investment objectives. In other words, Wal-Mart may carry an electric razor that also docks your iPod, but if you can't figure out why such a thing would be useful, don't buy it.