Mutual funds used to be the “go-to” investment for the average investor. And why not? They had a lot to offer. Their costs are low. They’re easy to invest in. They’re professionally managed. And they’re flexible. More importantly, they’re diversified. They offer the average investor a measure of protection from the stock market’s volubility.
But there’s a new kid on the block that’s challenging mutual funds—one you might want to do your homework on. This new kid on the block is exchange-traded funds (ETF). And it’s replacing the mutual fund as the go-to investment for the average investor. It’s ideal for personal retirement funds.
How hot are ETFs? There were more than 7,600 ETFs worldwide, with $7.7 billion in assets at the end of 2020. In the U.S., there were 2300+ ETFs with about $6.6 trillion assets under management at the end of 2021. Put simply, ETFs are among the most popular investment vehicles out there.
So, what is an ETF? They’re a cross between a mutual fund and a stock. Put another way, they’re an investor-friendly index mutual fund with some nice perks thrown in. Index mutual funds are investments vehicles with portfolios that match or track the components of a financial market index like the Standard & Poor 500 Index.
Index funds are a solid foundation upon which exchange trade funds are built. They’re an excellent way for you to create a simple, low-cost portfolio. ETFs’ investment benefits are what make them so attractive to investors. Below are five benefits ETFs bring to the table:
1. Fast portfolio diversification
This benefit is among the biggest of all, if not the biggest. With ETFs, you don’t have to invest a ton of money to gain many things to diversify. In fact, you only have to invest in one share of an ETF to gain access to many companies or bonds. Diversification reduces portfolio risk, acts as a hedge against portfolio risk, and generates higher returns long-term.
2. Less overhead
Fund managers don’t usually manage ETFs. They don’t have to managed them. They’re pegged to a benchmark index, so the fund’s money managers aren’t trying to beat the market. Passive investing like this is more cost-effective for investors because there is less overhead and fees, saving them money.
3. Lower fees
ETFs are low-cost. In fact, many ETFs charge less than 0.25% per year for expenses. But some brokerage houses charge fees for trades. So, if you’re buying an ETF, make sure you check this scenario out. Also, some ETFs have hidden costs, like expense ratio and the bid/ask spread. These costs can add up over time.
4. Easy to buy and trade
ETFs trade throughout the day, unlike mutual funds. In other words, ETFs trade throughout the day just like stocks. That gives ETFs a measure of flexibility, which is always good to have when it comes to creating a portfolio.
5. Tax efficiency
The big takeaway is that, comprehensively, ETFs produce fewer capital gains distributions overall. That makes them slightly more tax-efficient than mutual funds. Why? One reason is that ETFs have their own unique mechanism for buying and selling. They use creation units for buying and selling the fund’s assets collectively.
When it comes to tax efficiency, however, the type of securities in a mutual fund or ETF can significantly affect your taxes. So, check the securities out in an ETF before buying.
If ETFs sound like something you might be interested in adding to your portfolio or helping fund your retirement account, you should talk to an investment advisor. They can help you determine if ETFs are right for you.