As an investor, it’s important to learn about the different options available to you. One of those options is ETFs. But what are ETFs? The answer can help you determine whether they are one of investment strategies you may want to consider. Read on to learn more about ETFs and how they differ from other popular options such as mutual funds or stocks.
In this article:
What Are ETFs? | A Simple Guide to Exchange-Traded Funds
What Are ETFs?
Let us get down to business: what are ETFs? ETF stands for exchange-traded funds. The ETF market works similarly to a stock since you trade both in the stock exchange.
However, you do not deal with individual stocks in an ETF. Rather, you trade with securities divided into shares. These can already include bonds or commodity, among others.
ETFs are also not mutual funds. Prices rise and fall throughout the day, and since ETFs can be traded multiple times in the same day, they offer higher liquidity than most mutual fund shares. They can also have lower fees, so they tend to be more attractive than mutual funds.
ETFs were created to establish index-type funds for investors to trade at a greatly reduced cost of actual index funds, which have the potential to offer benchmark returns. While index funds are expensive to trade, many ETFs trade as commission-free ETFs.
Benefits of ETFs over Mutual Funds
Now you know the answer to “What are ETFs?” it is time to learn why it can be appealing to invest in them.
Forbes reports you may already be an investor in ETFs without even realizing it, so you may already be one step ahead. Either way, you have the opportunity to enjoy the benefits of having ETF shares, which include:
- Limited Capital Gains Exposure – ETFs can minimize capital gains because they are considered like-kind exchanges (and not subject to capital gains taxation) when traded. This reduces taxes when you sell funds since mutual funds can only be traded once a day.
- Lower Initial Costs – ETFs do not have the heavy investment minimums many mutual funds require. That makes the initial investment costs far lower than the average mutual fund.
- Fewer Internal Costs – ETFs also have lower fees associated with operating and maintaining them, such as the administrative fees, record-keeping costs, and advertising fees generally associated with mutual funds.
- Greater Control – While mutual funds are only traded once daily, ETFs are traded like traditional stocks and can be bought and sold multiple times within a day. This provides investors with greater control and liquidity in their investment. You can also have some control over the asset class. Besides stocks, you can also trade futures and options.
- Immediate Reinvestment of Dividends – Because you can trade ETFs throughout the trading day, you can reinvest the funds immediately without having to wait until the next day. The one caveat will be for trading unit investment trust ETFs, which you cannot reinvest.
Possible Disadvantages for Trading ETFs
Knowing what ETFs are and their benefits, it is easy to feel as if it is always the right decision. However, before you rush in headfirst and dive into trading ETFs, it is a good idea to balance things out. You need to understand the potential disadvantages of trading these types of assets.
These possible downsides can include:
- Potentially Lower Dividend Yields – Some ETFs offer high yields, but not to the degree high-yielding stocks or groups of stocks deliver.
- Larger Bid-Ask Spread than Other Options – There are many niche ETFs that operate in low-volume indexes. This makes the bid-ask spread larger than that of traditional stocks or managed funds.
- Unappealing to Some Traders – Some advantages do not benefit all traders such as those seeking long-term investment, growth, and stability. This is because to maximize the benefits of ETFs, you need to trade consistently.
When it comes to trading ETFs, the goal is to keep your philosophy simple. If you are looking for stability, work with ETFs showing a proven track record of success, low fees, and strong performance.
Understanding what ETFs are help you to get a good head start in your ETF investment journey. The next step, if you want to pursue this type of investment, is to research your options. Your best course of action there is to get help from advisors and do your research. Having a plan and a trustworthy guide to help you in making sound financial decisions according to your long- and short-term goals will help you as your dip your toes into ETF investing.
What are the things you like about ETFs? How about the cons? Tell us your thoughts in the comments section below.