Exchange-traded funds (ETFs) are a “hybrid” investment with characteristics of both stocks and index mutual funds. Like stocks, ETFs trade on stock exchanges and experience price changes throughout each market trading day. Like index funds, they consist of a portfolio of securities that is passively managed. This means that, by definition, ETFs consist of the securities that comprise a specific benchmark market index. ETFs were first introduced in 1993 and have seen tremendous growth in assets ever since.
The most popular ETF, so-called “Spiders” (trading symbol: SPY), an acronym for Standard & Poor’s Depository Receipts, tracks the Standard & Poor’s (S&P) 500 index of large company stocks. The second most popular ETF, formerly referred to as “Cubes” (trading symbol: QQQ) and now called Powershares QQQ, tracks the NASDAQ 100 index of small company stocks. There are also ETFs that track indexes for various industry sectors (e.g., energy, financial services, healthcare, real estate, and technology), different company sizes (e.g., large-, mid-, and small- capitalization stocks), and dozens of foreign countries or regions of the world (e.g., Europe and Asia).
Many ETFs have an even a lower turnover than managed mutual funds. Turnover refers to the frequency with which securities in an ETF portfolio are bought and sold. Changes in an ETF portfolio typically occur only when a change is made to the underlying index upon which it is based. This translates into extremely low expense ratios (i.e., expenses as a percentage of assets), as low as 0.09% (less than a tenth of 1%) to 0.11%, compared to about 0.18% for the least costly stock index mutual funds and much less than the average expense ratio of about 1.5% charged by actively managed (non-index) stock funds.
Another advantage of ETFs, compared to mutual funds, is that investors, themselves, can decide if and when to sell ETF shares and, by doing so, arrange the best timing to incur capital gains tax liability. In other words, investors have the same flexibility to buy and sell shares as they do with individual stocks. With mutual funds, on the other hand, taxable dividends and capital gains, as well as transaction costs, are automatically passed along to fund investors and taxed accordingly.
Below are some recommendations about exchange-traded funds provided by investment experts:
- Choose an ETF that reflects your financial goals and investment risk tolerance, just as you would do when selecting a stock or mutual fund. For example, if you are a very conservative investor, stick with a broadly diversified ETF, such as a “spider,” rather than a very narrowly defined ETF that invests in the stock of just one country or one industry sector.
- Consider how various ETFs match your asset allocation strategy and weight your purchases accordingly. Asset allocation is the percentage of an investor’s portfolio in various asset classes such as stocks, bonds, and cash equivalent assets such as Treasury bills.
- Start simple with just a few ETFs. The AAII (American Association of Individual Investors) Journal suggests three types of ETFs as core investments: a total stock market ETF (tracks all U.S. stocks), a total international ETF (tracks stocks from all foreign counties), and an intermediate-term U.S. government or municipal bond ETF for exposure to fixed-income securities. More sophisticated investors can add on additional layers such as large-cap, mid-cap, and small-cap ETFs and ETFs from specific regions such as Europe, the Pacific, or emerging markets (developing countries). “Cap” is short for capitalization, which is the share price of a stock multiplied by the number of outstanding shares.
- Consider ETFs for large, infrequent lump sum deposits (e.g., a settlement or inheritance) because trading costs are incurred each time a purchase is made. In other words, you need to go through a broker every time ETF shares are bought or sold. Consider using low-cost index funds for frequent periodic deposits such as contributions to an employer retirement savings plan and share purchases that are automatically debited from a bank account on a regular schedule (e.g., a $100 deposit on the 15th of every month).
- Read an ETF’s prospectus before investing. In it you will learn about a stock or bond ETF’s underlying index as well as characteristics of the ETF itself. Another good source of information is the ETF sponsor’s Web site, which will include a description of the ETF, performance data, and portfolio holdings.