FINANCE FAQ: WHAT’S AN ETF?

Finance FAQ is a series here on TDT all about answering those pesky financial questions that you have, but feel like you should already know the answer to. Today’s question: What’s an ETF?

Or, as my friend said last year (thanks for the post idea!), “I have no idea what an EFT is!”

The short definition:

An ETF is a group of investment assets that track a market index. It’s built like a mutual fund but trades like an individual stock.

The long explanation:

ETF stands for exchange traded fund. An ETF trades on the stock exchanges, like stocks do. And you can buy and sell it the exact same way that you invest in a stock. But rather than representing ownership in one company, the way a stock does, an ETF is actually a bundle of investments.

In that investment bundle, an ETF could hold a few different assets – stocks, bonds, and commodities (like gold). Technically, the fund holds the investments, and you hold shares of the fund. Most of the time, an ETF will reflect an index fund, like the S&P 500. An ETF/index could also track a sector, like healthcare stocks.

One important feature of ETFs is that almost all of them are passively managed. Passively managed essentially means that management is taking a “set it and forget it” approach to the fund. Since indexes are pre-determined groupings of stocks, there aren’t many investment decisions involved in running an ETF. They’ll pretty much only have to buy and sell shares in the ETF if the underlying index changes (like when the Dow started to include Apple).

ETFs are similar to mutual funds in a lot of ways, in that you’re purchasing a group of investments rather than one. In that way, both offer the useful benefit of diversification (buying a group of stocks tends to be less risky than buying just one as you have more “horses in the race”). That said, ETFs have some key advantages over mutual funds.

ETFs tend to be a lot cheaper than mutual funds. Unlike how most ETFs are passively managed, most mutual funds are actively managed. That means a portfolio manager is constantly surveying the market, and buying or selling shares for the fund. All of that activity creates cost for the fund – transaction costs for sales commissions, plus higher taxes if the sales profits are short-term (remember, long-term capital gains are taxed at a lower rate). Plus, there’s the cost of the portfolio manager. Who winds up paying those costs? You, of course.

Remember when I showed you how costly fund expenses can be over time? Mutual funds tend to have higher expenses – often around 1% of the amount you’ve invested – because of all of the costs they bear from active management. In contrast, the Vanguard average ETF expense ratio is 0.13%. ETFs also only require you have enough for a share, while most mutual funds require you to invest a minimum dollar amount – often $2,500 to $5,000.

Mutual funds and ETFs also trade on the market differently. Mutual funds are priced once a day after the markets close, while ETF prices fluctuate throughout the day just like a stock or an index does.

Granted, some ETFs charge the same commissions you pay on a stock, so that may eat into your cost savings. Another drawback is that you can set up automatic investments in most mutual funds, while you can’t automatically invest in an ETF.

The bottom line? ETFs can be a great way to diversify your portfolio at a low cost.

Let me know if you have more questions or requests for future Finance FAQ topics in the comments!