What is an ETF?

Exchange Traded Funds, otherwise known as ETFs, are essentially index mutual funds that trade like stocks.  ETFs’ popularity is growing in part because some of the biggest names in the financial services industry are promoting them as alternatives to regular, or open-ended, mutual funds.

What’s the benefit of an ETF?  First, most have a low expense ratio.  An expense ratio is simply the amount of money that the fund charges in fees.  A second advantage is that an ETF can be traded (bought or sold) any time that the market is open.  For example, if you believed that the stock market was going to go up during the day, you could buy a stock market index ETF in the morning and sell it in the afternoon and capture the gain (or loss).  You can’t do this on an intra-day basis with a regular open-ended mutual fund.

What are the disadvantages?  Up till now the buyer or seller of an ETF incurred a commission, just like the individual who bought or sold a stock.  This is not the case with no-load mutual funds that don’t charge a fee for either buying or selling.  That is in the process of changing as some of the biggest names like Schwab and Fidelity are offering free trades on a growing number of ETFs.

The other disadvantage for the typical investor is that most ETFs are index funds rather than actively managed.  That means that there is no-one actually making a decision about what stock or bond to buy, sell or hold.  Buying an EFT requires your active participation and management or you risk putting your investments on auto-pilot and hoping that they don’t crash.

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