Exchange Traded Funds, known as ETFs, have grown into the primary alternative to mutual funds for diversified investing. With recent changes in trading practices at brokerage behemoths Charles Schwab, Fidelity, and TD Ameritrade, the case for using ETFs is growing stronger.
If you’re an avid investor, you probably know that ETFs enable you to invest in hundreds of individual stocks or bonds with one trade. Perhaps best known is State Street Global Advisors SPY, which tracks the S&P 500 index of US large company stocks. Most ETFs are passively managed portfolios of stocks or bonds. These fund managers are not attempting to beat the market, but rather efficiently capture the returns of an asset class with low costs and tax efficiency.
You may wonder how they differ from low cost indexed mutual funds. Indeed if we compare the SPY ETF with the Vanguard 500 Index Admiral, you’ll find they have striking similarities. The expense ratio for SPY, which covers much of the fund’s overhead, is 0.095 percent annually. Vanguard’s similar fund has an expense ratio of 0.04 percent. That means the annual cost of investing $10,000 would be $9.50 and $4 respectively – almost free. Even cheaper are Fidelity’s new free index funds.
Indexed mutual funds and ETFs are both also known for their tax efficiency. When you invest in a retirement account, whether through work or in an individual traditional or Roth IRA, tax efficiency does not matter. When you save in a taxable account, that’s when it starts to make a difference. Tax efficiency means that income and other distributions are minimized and are subject to lower tax rates. While some say ETFs are more tax efficient, in truth the difference is small between a well-run ETF and a passively managed mutual fund.
Where ETFs shine is for active investors who trade midday. ETFs have prices that fluctuate throughout the day, largely tracking the index they follow. In contrast, mutual funds trade at the market close. Also mutual funds are bought and sold at Net Asset Value (NAV), the true value per share of all of securities held by the mutual fund.
Also ETFs give you the option to hold investments from many different companies in a single brokerage account at a low cost. With one discount brokerage account, you can trade Vanguard, SSGA, and iShares ETFs at minimal cost. In contrast, with mutual funds there will usually be transaction costs for buying and selling shares unless you’re buying one of the broker’s own mutual funds, such as a Schwab fund in a Schwab account.
Two recent moves that have roiled the brokerage industry make ETFs more compelling. First is that Schwab, Fidelity, and TD Ameritrade have all introduced free online stock trades including ETFs. So what was once low cost is now free. Second, Schwab has proposed fractional share trades for ETFs and other stocks. One advantage of mutual funds is that you can trade an exact dollar amount to the penny, while ETFs required trades in a whole number of shares. If SPY is trading at $303.33 and you want to invest $5,000, you’re forced to choose between 16 or 17 shares. Fractional shares will enable you to invest a greater percentage of your cash in ETFs.
While ETFs may have shed some disadvantages, some should give you pause. Like any other stock, ETFs have a bid and an ask price, which can introduce an additional cost particularly with funds that don’t trade as much. Also you may need to exercise more care purchasing ETFs and using strategies such as limit trades in order to receive the price you expect. Plus be careful trading ETFs in times of big market volatility as the prices can fluctuate more than the underlying stocks or bonds they hold. Finally, most should avoid highly volatile ETFs that are heavily leveraged and can behave unpredictably, unlike most of their passively managed cousins.
While investment aficionados may debate the merits of indexed mutual funds vs ETFs, save your breath. Both low cost ETFs and mutual funds have their benefits. If you’re interested in trading midday or holding the investment products from several companies in a single account, consider using ETFs especially if you’re willing to wade into some additional trading complexity. If you largely stick with one or two investment families such as Vanguard or Fidelity, consider emphasizing mutual funds. You can use either or both to carry out a well-designed investment strategy.