Despite being a relative new kid on Wall Street, exchange-traded funds (ETFs) have surged in popularity over the last two decades.
By the end of 2014, Bloomberg data revealed that the ETF industry reached a record $330 billion in new investments.
And there are few signs that interest in ETFs is waning.
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“ETFs have been growing for years,” says Ben Johnson, Chartered Financial Analyst, director of global ETF research for investment-research firm Morningstar. “But when the menu expands and expands, there’s risk for confusion.”
As with anything that generates buzz, it’s natural to have lots of questions—especially if you’re thinking about taking the ETF plunge with your own portfolio.
To help provide clarity on some of the myths, misconceptions and general confusion surrounding ETFs, we’ve rounded up eight common questions people may have—and tried to answer them in plain English.
1. What’s the difference between an ETF and a mutual fund?
Like index mutual funds, ETFs can hold a basket of investments and track a benchmark index, such as the S&P 500, the Dow Jones Industrial Average or the Russell 1000, to name a few.
But unlike mutual fund shares, the shares of an ETF are bought and sold throughout the day on a stock exchange through your brokerage account, just like the shares of an individual company’s stock.
Mutual funds, by contrast, trade only once a day, after the close of trading.
“The kind of [investment] exposure you get and the basic underlying function of an ETF are similar to those of mutual funds," says Matt Hougan, C.E.O. of ETF.com, an education and analysis site, "but the difference is that you can buy and sell [ETF shares] anytime during the [trading] day.”
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2. Do ETFs only track indexes?
Hougan estimates that 99% of ETFs track an index, and in most cases, the ETF manager might buy and sell shares only when the makeup of the fund’s underlying index changes.
That’s what makes many ETFs “passive” investments—they don’t require a manager to actively buy and sell securities with the goal of beating the underlying index. Rather, the aim is to mirror or closely track the performance of an index.
There are, however, some ETFs that zero in on specific industries, sectors or countries.
Others may be constructed using alternative measures to follow an index—for example, focusing on companies’ dividends or earnings histories, instead of the more standard market capitalization.
"It's important to note that the word 'index' doesn't necessarily mean what it used to," Hougan explains. “So just because an ETF technically tracks an index doesn’t mean that it’s giving you the broad-based exposure we traditionally associate with index-based investing."
There are also ETFs that track indexes of bonds, commodities, real estate and other assets, which investors may consider using to help strategically diversify their portfolios.
3. Are ETFs riskier than traditional mutual funds?
Since ETFs are still a relatively new investment offering, there’s often a misconception that they are riskier than mutual funds, which have been around for longer.
But as with mutual funds, much of the risk in an ETF is tied to its underlying holdings.
So, for instance, if your ETF holds U.S. stocks, it’s likely going to be less risky than, say, one that holds emerging-market stocks.
“ETFs can be a little more advanced than mutual funds because you buy them like you would stocks. But if you know how stocks trade, you’ll know how ETFs trade.”
4. Should only more “advanced” investors consider using ETFs?
“Absolutely not,” Johnson says. “ETFs have had a democratizing effect on the investment landscape. They’ve brought broad, useful and inexpensive exposures [to the market] to a full spectrum of investors—from large institutions to individuals.”
That said, “ETFs can be a little more advanced than mutual funds because you buy them like you would stocks,” Hougan says. “But if you know how stocks trade, you'll know how ETFs trade."
Both Johnson and Hougan, however, encourage beginner investors to steer clear of the more complex, actively managed ETFs.
“There are some ETFs out there that should be owned only by very sophisticated investors,” Hougan says.
Signs you’re dealing with a more complex ETF? The name might include words like “leverage” or “inverse.”
5. If you already own mutual funds, why would you consider adding ETFs to your portfolio?
Hougan doesn’t see this as an either-or question. “Mutual funds can live side by side with ETFs in a portfolio happily,” he says.
Among other advantages, ETFs can provide additional diversification to a portfolio because they cover virtually every type of asset class or sector out there, both in the U.S. and abroad.
You should consider carefully evaluating the underlying assets of an ETF against your mutual fund investments before you make any portfolio moves.
For example, if you already hold a U.S. large-cap mutual fund, Johnson says, you’re likely not getting additional diversification benefits by adding an S&P 500 ETF to your portfolio.
6. Is it true that ETFs have higher fees than other types of funds?
ETFs can trade throughout the day, and investors often think that equates to greater fees.
Generally speaking, this isn’t true.
Most ETFs tend to have low expense ratios—the annual fee that funds charge shareholders to cover operating costs—because of their passive management style.
Mutual funds, meanwhile, tend to be more actively managed and may therefore have higher fees. Although an index fund—a type of mutual fund that tracks an underlying stock index much the way an ETF does—can have an expense ratio comparable to that of ETFs.
Since ETFs are purchased and sold like stocks, you do however have to keep in mind trading costs and commissions, which can vary greatly by brokerage firm and could eat into your returns—unless you’re able to nab $0 commission or no-transaction-fee offers.
But one big cost advantage that ETFs have over mutual funds, says Hougan, is in the tax arena.
Due to a difference in the way ETF shares are created and redeemed—essentially, by swapping securities for securities, rather than selling them off for cash—ETFs tend to make fewer annual capital gains payouts to their shareholders.
7. Can I invest in ETFs through a retirement account?
ETFs are slowly starting to make an appearance as investment options in 401(k) plans, but you’re more likely to find them in IRAs, which tend to offer a wider variety of investments.
“One common mistake we see people make is assuming that all ETFs that say they are investing in one area of the market are the same.”
However, it’s worth noting that, in a tax-deferred retirement account, an ETF’s tax efficiencies aren’t an advantage.
That's because you don't pay annual capital-gains taxes—as you would in a taxable brokerage account—nor do you pay capital-gains taxes on the withdrawals you make in retirement.
8. Several ETFs seem to cover the same types of investments. Does it really matter which one I pick?
Yes—particularly if you’re interested in an ETF that doesn’t track a well-known index, like the S&P 500, in which it’s clear what you’d be investing in.
“One common mistake we see people make is assuming that all ETFs that say they are investing in one area of the market are the same,” Hougan says. “The reality is, there are significant differences between ETFs that have similar names, so [finding the right one matters].”
Two ETFs that both say they are tracking China, for example, could vary in performance by 30% or 40%, he explains. “So you have to look under the hood and make sure an ETF is giving you the exposures you want,” he says.
The good news is that ETFs tend to be quite transparent. ETFs are required to disclose their holdings every day, Hougan explains, while mutual funds may disclose their holdings only quarterly, and with a 30-day lag.
So before investing in an ETF, do your research to figure out what a fund’s investment focus is, what types of companies are in its portfolio, what its fees and expense ratios are, what its trading volume looks like, and how much it lags in performance to the index it is attempting to mirror.
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