Contents
ETF Fundamentals
Why Invest in ETFs?
Stock ETFs
Fixed-Income (Bond) ETFs
Real Estate (REIT) ETFs
Commodities ETFs
How to Build a Balanced Investment Portfolio with ETFs
How to Build a Portfolio with ETFs and Other Types of Investments
How to Buy ETFs for Your Portfolio
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Why Invest in ETFs?
The market for ETFs has grown exponentially in recent years, for good reason—ETFs are a highly efficient and effective way for individual investors to invest their money. Though it’s true that ETFs work like a hybrid of stocks and mutual funds, they actually have several advantages over those investments. These differences can make ETFs a better choice than individual stocks or mutual funds for many individual investors.
ETFs vs. Mutual Funds
Mutual funds are investments that pool money from many investors and invest it in a specific set of investments, such as a group of individual stocks or bonds. Actively managed mutual funds employ fund managers to hand-pick the fund’s investments on an ongoing, “active“ basis. Passively managed funds, also known as index funds, own investments that match those of a market index, just as ETFs do.
Though ETFs and mutual funds both allow investors to own a group of investments by buying just one investment, ETFs have several advantages over mutual funds:
- Lower expense ratios in many cases
- No minimum investment requirements
- Trading flexibility
- Tax advantages
- Protection against possible fraud
- Opportunities for options and short selling
ETFs Have Lower Expense Ratios
All mutual funds and ETFs have an expense ratio, a fee charged to shareholders to cover the costs that the firm incurs to manage the fund or ETF. Expense ratios are expressed as an annual percentage, such as 1.00%. An investor who owns $10,000 worth of a mutual fund with an expense ratio of 1.00% will pay $100 per year in fees to own the fund. ETFs have much lower expense ratios than actively managed mutual funds do. They also tend to have lower expense ratios than those of comparable index funds. Here are the average expense ratios of ETFs and mutual funds.
- Actively managed mutual funds: 1.50%
- Index mutual funds: 0.50%
- ETFs: 0.40%
Why Expense Ratios Matter
Though the differences between the average expense ratios of ETFs, index funds, and actively managed mutual funds might seem small, over time they affect returns (profits) substantially. The table below lists the returns you would get from an ETF, index mutual fund, and actively managed mutual fund with average expense ratios, assuming a $10,000 investment held for 30 years, with returns (before taxes and expenses) of 10% per year—which is roughly the annual return on stocks over the past 50 years or so.
Expense Ratio |
Total Before Expenses |
Total After Expenses |
Cost of Expenses |
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0.40% |
$174,494 |
$156,429 |
$18,065 |
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0.50% |
$174,494 |
$152,203 |
$22,291 |
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1.50% |
$174,494 |
$115,583 |
$58,911 |
The tiny 0.10% difference between the expense ratio of an ETF and an index fund adds up to a difference of $4,226 in fees over 30 years. The 1.10% difference between the expense ratio of an ETF and that of an actively managed mutual fund totals $40,846 in fees over 30 years. If all else is equal between two investments, the investment with the lower expense ratio is most likely the better choice.
ETFs Have No Minimum Investment Requirements
Nearly all mutual funds have minimum investment requirements—investors must purchase at least the minimum required amount in order to buy the fund. Minimums usually range from $1,000–3,000, though some can exceed $25,000. ETFs, on the other hand, have no minimum investment requirements.
ETFs Provide More Trading Flexibility
Stocks and ETFs change hands constantly throughout the standard trading day (9:30 a.m. to 4:00 p.m., Monday through Friday). Buying and selling mutual funds works differently. Though you can place orders to buy and sell funds at any time during the trading day, your orders won’t be fulfilled until shortly after trading ends at 4:00 p.m. each day. The delay that mutual funds impose on trading can be more than an inconvenience—it can also be costly. For instance, if the market rises or falls in response to a major news event, such as a shift in interest rates, you might want to buy or sell immediately, since the price of the investment might change substantially by the end of the day. ETFs let you buy or sell immediately—mutual funds don’t.
ETFs Offer Tax Advantages
Mutual funds incur a tax liability whenever their investments generate income or capital gains (profits from sales). Mutual fund shareholders pick up the tab for these taxes, which explains why an actively managed fund’s after-tax return is often several percentage points less than its pretax return. ETFs have two advantages over mutual funds when it comes to taxes:
- Lower taxes than actively managed funds: Turnover is the frequency with which a fund sells its investments. A high turnover rate often results in high tax bills, since capital gains on investments held for less than one year are taxed at higher rates than investments held for a year or more. Since the underlying indexes that ETFs and index funds track seldom change, ETFs and index funds rarely sell the investments they track, and therefore incur minimal tax liabilities. Actively managed funds, though, often have high turnover, which can generate sizable tax bills.
- Deferred tax bills: Mutual fund investors must pay taxes on their funds’ income or gains before they even sell the fund—for example, if you hold a mutual fund for 10 years, you’ll likely pay taxes on your earnings from that fund each year. ETFs let you defer paying taxes entirely until you sell. Deferring taxes lets you keep more of your money invested and growing, which can boost returns over time.
ETFs Reduce the Risk of Fraud
ETFs are generally more transparent than mutual funds. In the investing world, transparency refers to the ease with which an investor can gain access to information about an investment. ETFs tend to be transparent because they typically disclose:
- The specific components of the indexes they track
- The weighting of their components—the percentage that each investment occupies within the index
A mutual fund discloses the investments it owns only periodically, when it releases a new prospectus. But significant changes in the fund’s investments can occur between these updates; because of this lag, mutual fund investors must trust that the fund manager is operating in the shareholders’ best interest. The lack of transparency in the mutual fund industry has led to several notable instances of fraud, such as the after-hours fund trading scandal of 2003.
ETFs Offer Options and Short Selling
Options are investments that grant you the right to buy or sell a stock at a certain price at any point within a fixed period of time. If the stock goes up during that time and you have the right to buy it at a lower price, you make money. Short selling lets investors profit from a decline in the price of a stock. For instance, if you think oil prices will soon plunge, you might sell short the stock of an oil company, expecting its share price to plummet along with oil prices.
Options and short selling are both available with ETFs but not with mutual funds. Though anyone can buy ETF options or sell short ETFs, usually it’s best for most investors to avoid these strategies, as they’re both very risky.
Advantages of ETFs Over Individual Stocks
Though ETFs trade just like individual stocks, they have several advantages that distinguish them from stocks:
- Lower volatility
- Reduced risk
- Instant asset allocation
- Quick and cost-effective diversification
ETFs Have Lower Volatility Than Individual Stocks
Volatility refers to the degree to which an investment’s value changes over time. Investments with prices that vary often and widely are said to have higher volatility than investments whose value changes gradually, in small increments. Though the price of an ETF does change throughout the trading day, over the long term ETFs tend to have lower volatility than individual stocks. ETFs have lower volatility because they track an entire index of investments—and it’s rare for the value of an entire index to go up or down more than a few percentage points in a day. The value of an individual stock, however, can change dramatically based on various factors that affect that stock specifically. For instance, if the CEO of a corporation is arrested on fraud charges, the stock of his or her company could plunge in value. Few ETFs experience such volatility.
ETFs Are Less Risky Than Individual Stocks
Volatility is closely related to risk, the prospect that an investment will lose value. Volatility tends to correlate with risk, which in turn correlates with an investment’s return:
- The higher the volatility of an investment, the greater its risk and potential returns.
Though individual stocks offer the prospect of higher returns than lower-risk investments such as ETFs, they do so with much higher risk, especially in the short term.
ETFs Make Asset Allocation Easy
The various types of investments, such as stocks, bonds, and cash equivalents, are also called asset classes. Asset allocation is the process of determining the percentage of your investment portfolio that each asset class should occupy. Once you’ve determined the asset allocation that suits you best, you can build a portfolio with that allocation by buying ETFs. For instance, if you decide that your portfolio should contain 60% stocks, 30% bonds, and 10% commodities, you can buy just three ETFs that track separate stock, bond, and commodities indexes. That way, you can avoid the hassle and expense of researching and buying various individual stocks, bonds, or commodities.
ETFs Make Diversification Easy and Affordable
Diversification is the process of buying several types of investments within each asset class, such as various types of stocks or bonds. Many studies have shown that diversification can reduce risk without compromising returns over the long term. Since ETFs track the performance of an entire index of investments, they allow you to diversify easily and cost-effectively—with just a few ETFs, you can own a small slice of hundreds or even thousands of different types of stocks, bonds, and other investments. Attempting to build a diversified portfolio by buying individual stocks, bonds, and other types of investments, is much more risky, time-consuming, and costly than diversifying with ETFs.
An Example of Diversification with ETFs
Rather than own just one ETF for each of the various
asset classes in your portfolio, you can diversify by owning several types of stock ETFs, bond ETFs, and so on. For instance, if you intend to allocate 60% of your portfolio to stocks, you could buy one ETF that tracks an index of the entire United States stock market, such as Vanguard’s Total Stock Market ETF® (symbol: VTI). A better idea, however, might be to spread out your 60% stock allocation among various other types of stocks, such as international stocks. That way, if the U.S. market experiences a sudden decline, your entire stock allocation won’t necessarily experience a similar plunge in value. For more on ETFs that track indexes of certain types of stocks, see Stock ETFs.
The Two Main Drawbacks of ETFs
ETFs have two main drawbacks with respect to mutual funds and individual stocks: commissions and selection.
Commissions
Whereas you can usually buy and sell mutual funds without paying any transaction costs, you must pay a commission every time you buy or sell an ETF. Commissions may be charged on a per-share basis or as a flat fee per transaction. Commissions for online trades range from about $7–30 per trade, whereas commissions for trades made over the phone or by your broker can cost hundreds of dollars.
Commissions and Dollar-Cost Averaging
Having to pay commissions to buy ETFs makes it impractical to use an investment strategy known as dollar-cost averaging. In dollar-cost averaging, you buy the same investment at certain intervals over an extended period of time. The purpose of dollar-cost averaging is to reduce risk by not buying an investment all at once, only to see it plunge in value the next day due to a sudden downturn in the market. For instance, rather than buy $12,000 worth of a mutual fund all at once, with dollar-cost averaging you might buy $1,000 worth of the same fund once a month for 12 months. Dollar-cost averaging into a mutual fund would cost you nothing, whereas doing so with an ETF would cost at least $7–30 per transaction.
Selection
Though it’s true that there are hundreds of different ETFs and more being offered every month, there are roughly 10,000 mutual funds and 7,000 individual stocks. If you’re interested in buying a very narrowly focused investment, it may currently be impossible to gain exposure to that investment by buying an ETF. For instance, if you believe that the stocks of Eastern Europe–based companies will increase in value, you have several different mutual fund options, or you can buy any of the individual stocks of companies from that region.
Currently, it’s difficult or impossible to replicate certain types of investments by buying an ETF. That said, for the average investor, it’s usually not necessary—and often highly risky—to buy the types of investments not yet covered by ETFs. As more ETFs come to market, the industry is bound to gain more funds that focus on specific market niches.
| Acknowledgments & Disclaimer |
