Investing for the Future

sunshinecity, CC-BY, via flickr

ETF, in case you are not familiar with the term, stands for Exchange Traded Fund, which is an investment vehicle similar to a mutual fund, with some decided benefits. They have become increasingly popular among non-retirement fund investments over the past few years, even though they were first introduced 20 years ago. You may be more familiar with the very first ETF, the SPDR S&P 500 (NYSE: SPY), which tracks the index, although you may not have known that it was in fact an ETF.

One reason ETFs are becoming so popular is their diversity. They have been designed now to allow a small investor to participate in many fields where only institutional investors used to be able to play, such as commodities, swaps and derivatives.

There are precious metal ETFs, foreign currency ETFs, bond ETFs, real estate ETFs, and more. There is probably an ETF that can cover nearly any investing idea that you can imagine. And although there are thousands of mutual funds available, they may be limited as to the products they can invest your money in.

A second reason for favoring ETFs over mutual funds is their complete transparency. ETFs disclose their exact holdings daily, at the end of the day. Every product, and as a percentage of the fund’s total holdings. Mutual funds, on the other hand, generally disclose their holdings only once a quarter, and even this information comes with a substantial time lag. By the time you can see your mutual fund’s holdings, they are possibly completely different from what the fund is currently holding.

Thirdly, ETFs trade and are priced continually, so there is never a time lag in the price you see. You can trade an ETF any time of the day, so you are able to exit quickly if you see something bad happening to the price. This is unlike the pricing methodology for mutual funds, which are priced (and trade) only once a day, at the end of the day.

ETFs can be purchased in small dollar increments, and do not carry the minimum investment amounts that many mutual funds do. However, it must be noted that ETFs can only be purchased in full shares, like a stock. It is possible to purchase partial shares in mutual funds, thus putting the entire investment amount to work, which may be a point in their favor.

The fifth reason: One of the major advantages to investing in ETFs as opposed to mutual funds is the tax efficiency angle. Mutual funds are constantly rebalancing, selling shares to raise cash to meet redemption requests, which triggers a taxable event. These capital gains (and losses) are passed along to the investor, whether or not the investor sells any shares in the mutual fund.

An investor in an ETF does not “redeem” shares, he merely sells them to another investor, so there is no taxable event to the fund itself. In this way, an investor can hold an ETF forever and never incur any capital gains taxes. Or the investor can time his sales in order to take capital gains (or losses) when he wants them.

You can also employ much more complicated strategies with ETFs than you can with mutual funds. Do you want to buy on margin? You can do that. Do you want to sell a sector short? You can do that. Do you want to utilize an option strategy? You can do that.

And the final reason why ETFs are better than mutual funds is their incredibly low expense ratios. An actively-managed large-cap mutual fund may incur on average, 1.3 percent per year in expenses. An average large-cap index mutual fund may have expenses of 0.71 percent per year. But the average large-cap ETF incurs only 0.33 percent in annual expenses. This ½ to 1 percent per year can add up to a huge difference in overall returns over an investor’s lifetime.

Let’s look at those differences in the S&P 500 Funds and ETFs. The index itself, the S&P 500, is up 14.96 percent this year.

The SPY ETF has an expense ratio of 0.09 percent. Rock bottom. Its year-to-date return is 13.55 percent.

One of the lowest-cost fund companies, Vanguard, has an S&P 500 Index fund, the Vanguard 500 Index fund (VFINX). Its annual expense ratio is still quite low, but is almost double that of the ETF, at 0.17 percent, and its return year-to-date is 13.39 percent.

Another S&P 500 Index fund, whose expenses are not as low as Vanguard’s, is the Shelton S&P 500 Index Direct fund, with a year-to-date return of 13.01 percent and annual expenses of 0.36 percent, nearly four times the ETF expense rate.

Clearly, if the investment vehicles are all made to track the exact same basket of stocks, the difference in return can be attributed to the management fee. Shouldn’t you choose the one with the absolute lowest fees, in order to reap the largest return?