ETFs, or Exchange Traded Funds, are a good investment for many people. ETFs give everyone the ability to buy a diversified basket of shares of an index, or play a sector without having to buy individual stocks. ETFs trade on the stock market, just like stocks. They are somewhat similar to a traditional closed-end fund, but with some additional advantages.
ETFs give the small investor the ability to buy the stocks represented by an index or a sector with a very small investment. For example, the S&P 500 Spider (SPY) recently closed at $148.62. The minimum investment in most traditional S&P 500 Index funds is much higher. A small investor with a few hundred dollars could buy this ETF with only the additional cost of a small brokerage commission. With today’s online discount brokerages, this might be as little as $7.
There are many specialized ETFs, so you can play a sector without a huge commitment. For example, the iShares MSCI Mexico Index Fund (EWW) recently closed at $57.08 a share, and has a five-year annualized return of 28%. Of course, sector funds are not without risk.
Large investors can also take advantage of ETFs. ETFs are repriced several times a day. They can be bought or sold any time the exchanges are open. If an investor needed to sell a traditional open-ended fund, the price would be based on the value of the shares at the end of the day.
ETFs are based on stock market indices and are very transparent. The investor can easily know what he or she is buying. It’s not always so clear what is held in a traditional open-end mutual fund, since the manager only has to report fund holdings periodically. Turnover and fees are typically lower than in actively-managed funds, and capital gains distributions are often much lower as well, because of the lower turnover. This can help reduce taxes on taxable accounts. While an actively managed open-end fund is good for some investors, if you already know in what you want to invest, there is no need to pay extra for that service. Just buy ETFs. Most fund managers don’t consistently beat the indexes, anyway.
One disadvantage of ETFs is that you pay a brokerage fee every time you buy or sell, so they are not really suitable for dollar-cost averaging small monthly investments. In this case it would probably be better to save up the funds and then invest a lump sum or use a traditional mutual fund.
ETFs are constructed in such a way as to minimize the spread that is common with other types of closed-end funds. Large blocks of ETF shares can be converted to their underlying stocks by institutional investors, which they will do if shares are discounted significantly to the individual stocks’ underlying value. Similarly, if there is a great premium over the shares’ underlying value, new shares can be created. This arbitrage factor built into ETFs tends to keep the discount or premium spread fairly small.
Exchange Traded Funds are a very good investment for both small and large investors who do their own homework, like to pick their own investments, and who don’t need the services of an active mutual fund manager.
Disclosure: the author owns shares in the iShares MSCI Mexico Index Fund.