For nearly a century, traditional mutual funds have offered many advantages over building a portfolio one security at a time. Mutual funds provide investors instant diversification, professional management, relative low cost, and daily liquidity.
Exchange-traded funds (ETFs) take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. As with all investment choices there are elements to review when making an investment decision. Most informed financial experts agree that the pluses of ETFs overshadow the minuses by a sizable margin.
Positive aspects of ETFs
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
Trading flexibility
Traditional open-end mutual fund shares are traded only once per day after the markets close. All trading is done with the mutual fund company that issues the shares. Investors must wait until the end of the day when the fund net asset value (NAV) is announced before knowing what price they paid for new shares when buying that day and the price they will receive for shares they sold that day. Once-per-day trading is fine for most long-term investors, but some people require greater flexibility.
ETFs are bought and sold during the day when the markets are open. The pricing of ETF shares is continuous during normal exchange hours. Share prices vary throughout the day, based on the changing intraday value of the underlying assets in the fund. ETF investors know within moments how much they paid to buy shares and how much they received after selling.
The intraday trading of ETF shares makes it easy to move money between specific asset classes, such as stocks, bonds, or commodities.
Trading traditional open-end mutual funds is more challenging and can take several days. First, there is typically a 4:00 pm Eastern standard time cutoff for placing open-end share trades. That means you do not know what the NAV price will be at the end of the day. It is impossible to know exactly how much you will receive when selling shares of one open-end fund or know how much you should buy of another open-end fund.
The trade order flexibility of ETFs also gives investors the benefit of making timely investment decisions and placing orders in a variety of ways. Investing in ETF shares has all the trade combinations of investing in common stocks, including limit orders and stop-limit orders and options. ETFs can also be purchased on margin by borrowing money from a broker. Every brokerage firm has tutorials on trade order types and requirements for borrowing on margin.
Short selling is also available to ETF investors.
Portfolio diversification and risk management
Investors may wish to quickly gain portfolio exposure to specific sectors, styles, industries, or countries but do not have expertise in those areas. Given the wide variety of sector, style, industry, and country categories available, ETF shares may be able to provide an investor easy exposure to a specific desired market segment.
ETFs are now traded on virtually every major asset class, commodity, and currency in the world. Moreover, innovative new ETF structures embody a particular investment or trading strategy. For example, through ETFs an investor can buy or sell stock market volatility or invest on a continuous basis in the highest yielding currencies in the world.
In certain situations, an investor may have significant risk in a particular sector but cannot diversify that risk because of restrictions or taxes. In that case, the person can short an industry-sector ETF or buy an ETF that shorts an industry for them.
For example, an investor may have a large number of restricted shares in the technology industry. In that situation, the person may want to short shares of a technology sector ETF. That would reduce one's overall risk exposure to a downturn in that sector.
Lower costs
Operating expenses are incurred by all managed funds regardless of the structure. Those costs include, but are not limited to, portfolio management fees, custody costs, administrative expenses, marketing expenses, and distribution. Costs historically have been very important in forecasting returns. In general, the lower the cost of investing in a fund, the higher the expected return for that fund.
ETF operation costs can be streamlined compared to open-end mutual funds. Lower costs are a result of client service–related expenses being passed on to the brokerage firms that hold the exchange-traded securities in customer accounts. Additionally, ETFs do not charge a 12b-1 fee, the annual marketing fee.
Brokerage companies issue monthly statements, annual tax reports, quarterly reports, and 1099s, and ETFs are generally included in those statements. The reduced administrative burden of service and record keeping for thousands of individual clients means ETF companies have a lower overhead, and at least part of that savings is passed on to individual investors in the form of lower fund expenses.
Another cost savings for ETF shares is the absence of mutual fund redemption fees. Shareholders in ETFs avoid the short-term redemption fees that are charged on some open-end funds. For example, the Vanguard REIT Index Fund Investor Shares (
Tax benefits
ETFs have a major tax advantage 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 sales of the ETF.
