Learn the Secrets of Successful ETF Investing
Exchange-Traded Funds are winning over more investors, especially beginners.
— -- In recent years, you’ve probably heard the abbreviation ETF and wondered what it means. These low-cost investment vehicles are definitely something that investors should become familiar with, especially when starting down the road to building wealth.
ETF stands for exchange-traded fund. The overwhelming majority of these investments are similar to index mutual funds. But instead of being managed by investment managers, ETFs generate returns by owning shares that match the composition (and therefore the returns after fees) of specific indexes.
ETFs aren’t as well-known as mutual funds and most corporate 401(k) plans don’t offer them. That’s a shame because they have some real advantages over mutual funds. First offered in the 1990s, ETFs have gradually grown in popularity to hold $2.1 trillion in assets.
Unlike shares of index mutual funds, ETFs can be bought on the exchanges during the trading day at their current price, just like a stock. Index mutual fund shares, however, can only be bought or sold at the close of the trading day. This flexibility of ETFs gives investors the opportunity to get in or out quickly to seize opportunities or minimize damage from falling values.
This difference can be a both a blessing and a curse. “The biggest advantage of ETFs is the biggest disadvantage,” says Mark Salzinger, editor and publisher of The Investor’s ETF Report, a monthly newsletter on the subject. “So those who invest in them can act like a trader. This seems great on the surface, but it isn’t good for most people because fear and greed can enable a short-term orientation, which can hurt them.”
What Salzinger means is that, while being able to trade ETF shares at the drop of a hat can be a good thing for those with the skill to do it right, it’s not really necessary for many individual investors who are interested in the long term.
Yet, there are other advantages of ETFs that can benefit individuals, especially if they have the discipline not to trade every time they see a big price movement in the indexes to which their ETFs are linked. These advantages include:
- Lower costs. ETFs tend to be the cheapest funds you can own. The average ETF expense ratio — the percentage taken out of accounts annually to pay the cost of operating the fund — fell to 0.23 percent at the end of 2015, according to Morningstar, the fund-rating company. While some others have expense ratios of about one half of one percent, ETF expenses range down to an ultra-low one-twentieth of 1 percent.
Over the long haul, differences in ETF fees can make a big difference in total returns. For example, let’s say you invest $10,000 in two ETFs and add $5,000 a year to these investments for 20 years. Both generate a 10 percent annual return. Over this period, one of the ETFs, with expenses of five basis points (.05 percent), returns $270,000 (over and above the money you invested). The other, with expenses of 55 basis points (.55 percent), returns $238,000. Both ETFs track exactly the same index, so their gross returns are the same. Thus, the only issue is expenses, which has a big impact on net returns over time —a difference of $32,000 in this example.
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