According to the SEC, an Exchange Traded Fund is:
Exchange-traded funds, or ETFs, are investment companies that are legally classified as open-end companies or Unit Investment Trusts (UITs), but that differ from traditional open-end companies and UITs in the following respects…
You can find the rest of the SEC’s definition here or keep reading to find out what you really need to know about ETFs:
1. ETFs are not investments, they are a way to invest.
ETFs are not an asset class like a bond or a stock. Rather, they are a vehicle for investing in stocks, bonds, gold, oil and several other asset classes.
2. ETFs are not stocks or mutual funds, they’re ETFs.
ETFs are often described as a cross between a stock and a mutual fund and that is true to the extent that ETFs offer the best of both worlds.
ETFs are like stocks in that you can buy and sell them the same way. ETFs are traded on the major markets and the price is set by buyers and sellers in real time. Compare that to mutual funds where you are forced to trade with the manager who unilaterally sets the price after the market closes.
ETFs are like mutual funds in that they offer a quick, easy way to diversify your investment – for example, ETFs must hold a minimum of 20 securities. Investing in just one stock will help you gain exposure to an industry trend, but also leave you vulnerable to “single stock” risk – the possibility that a stock blows up due to issues unrelated to the industry or economy (think Enron).
The kicker is that the market doesn’t reward you for taking “single stock” risk – you will do just as well in a diversified portfolio with less risk. For proof, google “Harry Markowitz” and “Nobel Prize”.
3. ETFs are for individual investors as well as for the pros.
Although the professionals discovered ETFs first, individual investors can benefit just as much from using them for long term investing.
First, since ETFs were only introduced a few years ago, they offer several advantages over mutual funds which are burdened by characteristics from their original introduction in the 1930s. For example, ETFs are low-cost and tax efficient relative to most mutual funds. In many cases investors can save 200 – 300 basis points (2 – 3%) every year with ETFs and that’s compared to a NO-load mutual fund (for more see our earlier post ETF ACADEMY: Mutual Fund Tax Nightmare).
Second, ETFs come in a lot flavors (almost 700 at last count) to fit almost any situation. For example, if you are just beginning to save and invest, plain vanilla ETFs are available at very low cost to get you going. On the other hand, if you have a very complicated portfolio, you can find very specialized ETFs to fill in a hole or mitigate risk.
4. You can invest a small amount on a regular basis without getting crushed by commissions.
Since you buy ETFs the same way that you buy stocks, you will have to pay a commission. However, some innovative brokers have introduced programs that let you buy small amounts on regular basis for only a small fixed fee. For example, see our earlier post Pros and Cons of ETFs where we mentioned Sharebuilder.com and their 20 trades for $20 program.
5. If your financial advisor is not actively suggesting ETFs, find another advisor.
If you just can’t bear to part with your FA, at least do them a favor and send them this post!