Exchange traded funds (ETFs) can be a great addition to an investor’s portfolio. This post will talk about what ETFs exactly are, how they’re different from other investment types, and share tips on how to choose them.
In this article:
- Exchange Traded Funds vs. Mutual Funds
- Roth IRA Investments in Exchange Traded Funds
- Tips For Choosing Exchange Traded Funds
Exchange Traded Funds (ETFs) for Your IRA – An ETF Guide
What is an ETF or Exchange Traded Fund? ETFs are marketable securities whose market values or market prices follow those of other financial assets.
Marketable Securities Definition: Financial securities or instruments that investors can sell easily at a reasonable price, such as shares of stocks listed in the New York Stock Exchange (NYSE) or Nasdaq.
These financial assets include, among others:
- Stock indices
Exchange Traded Funds vs. Mutual Funds
Similarities With Mutual Funds
ETFs are often compared to mutual funds because of their similarities. One of them is the fact that both are pooled funds that offer shares or units of ownership in the fund.
As pooled funds, ETFs and mutual funds are both managed funds. This means investors have the benefit of having fund management companies with professional fund managers manage their investments in such funds.
Regardless of their similarities, there are differences in investing between the two kinds of funds.
Differences Between ETFs and Mutual Funds
An ETF is different from a mutual fund in several ways.
|Setting Prices||Investors can buy and sell mutual funds at a price called net asset value (NAV), which mutual funds companies determine at the end of the previous day. As such, the buying and selling prices of mutual funds are fixed throughout the day and change only the next day.||Exchange traded funds trade the way stocks do in stock exchanges like the NYSE and Nasdaq. Investors can trade ETF shares any time during the day at their last traded price, which changes throughout the day.|
|Quantity of Shares||Investors can trade whole shares or fractions of a share of mutual funds (e.g. An investor can buy 1.34 shares, 2.76 shares, or 5 shares of mutual funds).||Investors can only trade full shares of ETFs (e.g. An investor can only buy whole-numbered shares of ETFs, e.g., 50, 20, 1,000 shares).|
|Minimum Investment Amounts||Mutual funds companies usually require high minimum investment amounts.||ETFs don’t impose such requirements on individual investors.|
|Fees||When investors buy or sell mutual funds, they usually have to pay loading fees that usually go to the financial advisors who sold them the mutual funds.||While there are also many mutual funds that don’t charge loading fees, no ETFs charge loading fees. In lieu of loading fees, investors pay commissions to the broker through which they trade exchange-traded funds. And in most cases, the commission brokers charge ETF investors is a flat fee, which makes trading larger volumes more cost-efficient.|
|Expense Ratio||Often have higher expense ratios than ETFs||Often have lower expense ratios. Since ETFs are a passive-management investment, their expense ratios are comparable with those of passively-managed mutual funds.|
Expense Ratio Definition: The cost of managing an ETF or a mutual fund.
Roth IRA Investments in Exchange Traded Funds
Investors can passively invest in ETFs because professional investment management companies actively manage them. As such, investors may enjoy higher average annual returns on investment compared to managing their investments themselves.
ETFs may provide better passive investment returns than mutual funds. This is because exchange traded funds charge lower fees and cover more financial markets.
Tips For Choosing Exchange Traded Funds
Many investors make exchange traded funds their investment portfolio’s foundations. By investing in just a couple of ETFs, investors can diversify their portfolio holdings across many stocks or other financial assets of varying levels of market capital.
Of all the different kinds of ETFs, those that track the stock market appear to be some of the most, if not the most, popular ones. While many stock-related ETFs use different tracking indexes, many investors go for those that use the S&P 500 index.
1. Determine the Best Kind of ETF that Aligns With One’s Investment Strategy
Stock market-related ETFs come in different combinations. These include:
- Small-Cap ETFs: These types of ETFs contain stocks of exchange-listed companies that are at the bottom in terms of total market capitalization. One of the most popular indexes used for small-cap ETFs is the CRSP U.S. Small-Cap Index, which includes stocks of companies that ranked between the bottom 85% to 98% in terms of market capitalization or value.
- Mid-Cap ETFs: As the name indicates, these ETFs follow indexes containing exchange-listed stocks with medium-sized market capitalization, which is between $1.60 to $6.80 billion. Mid-Cap ETFs use the S&P MidCap 400 index as the main tracking index.
- Large-Cap ETFs: These ETFs track indexes comprised of the country’s biggest market-capitalized exchange-listed stocks. The most popular indexes for this type of ETF are the S&P 500 index, which contains stocks that make up about 80% of the entire market capitalization of the United States stock market, and the Russell 1000, which contains the 1,000 largest capitalized stocks in the Russell 1000 index.
- Total Stock Market ETFs: These exchange traded funds include shares of stocks of practically every publicly listed company in the United States, from those with billions of dollars in capitalization to those with only $3 million. The pioneering total stock market ETF is the Vanguard Total Stock Market ETF, which holds more than 3,500 stocks of all market capitalization sizes.
2. Learn More About the Transaction Costs that Come With an ETF
Investors should consider transaction costs as a very important factor when choosing ETFs. As mentioned earlier, investors can trade ETFs only through brokerage firms, just like trading stocks.
Fortunately, there are brokers that offer ETFs with no commission fees, which greatly reduces or minimizes their trading or transactions costs. Hence, it’s important that investors choose brokers that provide a comprehensive list of commission-free exchange traded funds.
Investing in exchange traded funds can be a very good way to optimize return on investment while diversifying one’s portfolio and minimizing investment-related transactions costs. So, knowing the answer to “What is an ETF?” and how it can be beneficial for investors.
Which characteristic of exchange-traded funds did you appreciate the most?We’d love to hear from you so let us know in the comments section below!