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Are Exchange Traded Funds Right for You?

Are You Ready to Play With the Big Boys?

Today I saw a clip on CNN Money.com with Suze Orman, in which she explained why she’s lost her faith in good old-fashioned index funds and is now a believer in the ETF. Which of course begs the question, what is an ETF?

An Exchange Traded Fund (ETF) is an investment that looks like an index fund but acts like an individual stock. First let’s dissect the name: Exchange Traded Fund. It’s a FUND that’s TRADED on an EXCHANGE (the American Stock Exchange). When you break it down like that, it seems pretty simple. But wait, there’s more.

An ETF looks like an index fund because it is an investment in a group of stocks that make-up a stock index, like the S&P 500, or the Dow Jones Industrial Average, or whatever. See my post on the Dow Jones Industrial Average for more info on what a stock index is.

But unlike a regular old index fund, the ETF acts like a stock because investors actively trade them while the stock market is open. This is different from a regular index fund or mutual fund, which has one price at the end of the day that you would pay if you wanted to buy it. With an ETF, the price of buying or selling shares changes throughout the day. You buy shares of an ETF through a brokerage firm like Vanguard. Anytime you want to buy or sell your shares, you will get hit with a transaction fee. But balancing out the detriment of transaction fees is the benefit that ETFs generally have lower expense ratios than most index funds. In the long run, a lower expense ratio can save you thousands, if not hundreds of thousands of dollars.

Another benefit of ETFs is that you don’t have to pay capital gains taxes on your earnings until after you finally sell the ETF. With a regular, non-tax-advantaged mutual fund, gains on the individual stocks in the fund are taxed periodically, and those costs come out of your investment. With an ETF, your money continues to make money for you as long as you hold the ETF, without the intermittent hits from capital gains tax.

So what’s the bottom line? ETF’s are something to consider if:

1. You’re already maxing out your tax-advantaged retirement accounts (IRAs and 401Ks)
2. You have a large chunk of cash ($10,000 or more) that you want to invest all at once, rather than investing a little bit every month (to minimize transaction fees)
3. You’re okay with holding that investment for a couple of years or more (to activate the capital gains tax advantage)
4. You want to diversify your portfolio by buying a broad mix from an asset class that you don’t already own (such as international, small-cap, or bond funds)

When you’re picking an ETF, be sure it has a super-low expense ratio and that it indeed follows a broad index. Check out this article on ETF fads to avoid. And as always, talk to an investing and tax professional before making this kind of decision.