For most investors, the term "exchange traded fund" is just financial gibberish. Given the many advantages ETFs have over mutual funds, though, it’s worth getting to know them a little better.
There has been a lot of talk recently about exchange traded funds, or ETFs. Some of you may already be familiar with them, but for most investors the term "exchange traded fund" is just financial gibberish. Given the many advantages ETFs have over mutual funds, though, it’s worth getting to know them a little better.
In financial-speak, ETFs are index-based baskets of securities offered for sale on a national stock exchange. They generally combine the trading flexibility of individual stocks with the diversification benefits of mutual funds. That's a mouthful, but what it really means is ETFs are a lot like mutual funds, only better in many cases.
For example, ETFs are generally cheaper than mutual funds, with annual expense ratios ranging from 7 to 75 basis points. Contrast this with actively managed mutual funds that on average charge investors over 135 basis points (and this doesn’t include the additional load fees, 12(b)-1 marketing fees, and transaction costs most mutual funds also tack on).
ETFs are also more tax-efficient than mutual funds. Unlike actively managed mutual funds, which spin off taxable capital gains to shareholders, ETFs only generate capital gains when you sell them. Moreover, due to their unique legal structure, ETFs are also more tax-efficient than their passively managed index mutual fund counterparts.
Third, ETFs give you more flexibility than mutual funds. Because they are traded on exchanges just like stocks, they can be bought and sold through your broker without restriction during the trading day. In contrast, most mutual funds are subject to short-term redemption fees or have other restrictions on when they can be sold. And even those funds that do not have trading restrictions can still only be traded outside normal market hours.
Fourth, ETFs allow you to easily customize your portfolio. There are nearly 500 ETFs sponsored by a variety of institutions, including State Street Global Advisors, Barclays Global Investors, PowerShares, and Vanguard Group. These ETFs focus on dozens of different market sectors, including bonds, technology, alternative energy, water, gold, oil, and private equity. As a result, investors can mix and match them to achieve a desired portfolio balance, emphasizing certain sectors while staying away from others depending on market conditions.
Fifth, ETFs are more cash efficient than mutual funds. Since ETFs don't need to maintain a cash position to satisfy redemptions, they can be fully invested in securities. This usually allows them to outperform similar mutual funds, which often incur a substantial cash drag.
Finally, ETFs offer more sophisticated hedging options for experienced investors. Because ETFs can be bought on margin or sold short like a stock, they allow experienced investors to implement sophisticated hedging, market-neutral, and other alternative investment strategies.
Exchange traded funds aren't for everyone, though. Because they are traded on stock exchanges, you incur a brokerage commission when you purchase or sell them. As a result, if you are making small regular contributions to your investment account, you'll often end up being swamped in commissions.
David A. Twibell, J.D., is president of Private Wealth Management for Colorado Capital Bank, where he directs the bank’s portfolio management and wealth advisory practice. He can be reached at (303) 814-5545 or firstname.lastname@example.org.