Should You Invest with Exchange Traded Funds?

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I want to be a smarter investor.

In my continued effort to be a more intelligent investor and to know more about investing outside of the 401K, I’m tackling the subject of exchange traded funds (more commonly referred to by their acronym, ETFs).

Most novice investors have heard of stocks and mutual funds (a combination of stocks).

Some may even be familiar with index funds, the mutual fund that mirrors a stock market index. But ETFs are still a mystery to most.

This makes sense too because most people never get beyond investing within their 401K. So if you’re thinking of opening a Roth IRA, you should definitely consider learning about ETFs.

Exchange Traded Funds (Definition)

Generally speaking, ETFs are a group of investments put together and usually tied to an index (like index funds) that you can buy shares in and trade like stocks.

So basically, you get the diversification that comes with grouped investments, the low-cost that comes with “passive” funds, and the flexibility of someone trading in stocks. ETFs have been around since the early nineties, but came on strong in the last 10 years.

I suspect the creation of the Roth IRA had much to do with this growth. Exactly how ETFs are different from mutual funds from a composition (how they’re put together) stand point is a bit over my head.

If you want further reading on these exact differences, I suggest you read Investopedia’s explanation of how ETFs are constructed.

List of Popular Exchange Traded Funds

There are almost a thousand ETFs available now. There were only 2 in 1997. Crazy. Some of the more popular funds are some of the older, broad-based funds. And this makes sense because people typically invest in what they understand. Here are the top ten ETFs based on volume:

  • SPY – SPDR S&P 500
  • XLF – Financial Select Sector SPDR6
  • QQQQ – PowerShares QQQ
  • EEM – iShares MSCI Emerging Markets Index
  • IWM – iShares Russell 2000 Index
  • FAS – Direxion Daily Financial Bull 3X Shares
  • FAZ – Direxion Daily Financial Bear 3X Shares
  • SDS – ProShares UltraShort S&P500
  • TZA – Direxion Daily Small Cap Bear 3X Shares
  • FXI – iShares FTSE/Xinhua China 25 Index

In addition to these broad funds, you can invest in commodity ETFs (i.e. Copper ETF), small-sector ETFs, foreign ETFs, etc. Not all ETFs are created equal.

Some are more actively managed and thus, more expensive.

ETF Trading

You can purchase shares in ETFs at one of the discount online stock brokers or at a mutual fund company like Vanguard.

Keep in mind that at a place like Vanguard you’ll have to commit several thousand to a brokerage account before you can participate. Also, keep in mind that not all firms charge a commission for trading ETFs. So be sure to compare trading costs.

ETFs vs Index Funds

For the long-term investor looking for diversified, low-cost investments, the ETF makes a lot of sense versus the normal mutual fund. However, when you compare ETFs with index funds, it gets a little harder to choose.

At the end of the day, it’s not going to matter a great deal which route you choose.

They are both great products, generally speaking. But just for comparisons sake, keep in mind these factors:

  • ETFs can be traded like a stock.
  • ETFs usually require you to pay a broker commission.
  • ETFs usually don’t allow for an automatic investing plan.
  • ETFs come in many more varieties.
  • ETFs have fewer “internal” expenses.
  • ETFs can help you avoid capital gains taxes in taxable accounts.
  • ETFs can usually be purchased in smaller amounts.

Noting those points, I’d say that an ETF is for someone who is into low-cost, active, taxable investing, OR the beginning low-cost, tax-deferred investor who doesn’t have a lot to invest.

What do you think? Do you invest with ETFs? Why?

photo by Lukjonis

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  1. Most ETFs are indexed. Example: SPY mirrors the S&P 500 and AGG mirrors the Barclays aggregate bond index.
    A big advantage in my opinion is that you know what price you are paying or getting as soon as you make the transaction. In fact, you can put in a limit order etc.
    Forget about having to wait until the end of the day to see what the price is and forget about expenses like 12-b and redemption charges and all that garbage that just confuses people and subtracts from the bottom line.
    Now ETFs make it possible, finally, for the small investor to trade like the the institutional investors.

  2. Great rundown of the specifics of ETFs!
    Two factors that I’d like to point out with regard to ETFs that *can* be considered negatives that you need to be aware of:
    1) no dividend reinvestment – unlike your mutual fund, an ETF does not have the mechanisms in place to allow you to automatically reinvest the dividends in the fund. This can be dealt with by periodically investing the cash dividend into the fund (perhaps once it has reached a level where the trade commission is a minimal percentage). For most folks this is no big deal, but if you’re trying to maintain efficiency in your investments it’s an extra step and an extra cost that you have to enact manually.
    2) NOT ALL ETFs ARE INDEXES – this is important to note. While most ETFs are connected to an index, some of the newer ones are not indexed, but are a sort of semi-managed fund. It doesn’t take long to figure this out if you look at the underlying fund information and see that it doesn’t reference an index. Costs for these ETFs are usually much higher as well. Caveat emptor!

  3. Avatar kt- lifedividend says:

    i would invest in them if anything for the advantages that you have stated above like long term low cost investment. But seeing as how they share this advantage with index funds, i would mix them up. But i prefer index funds to ETFs because i can basically invest in an index fund and forget about them for a majority of the time and in some cases i would beat the pro money managers at their game because money managers rarely beat the market. The fact that index funds have very little human interference makes them hugely attractive to me

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