NEWSLETTER

Written by Jimmy Becker

ETFs — WTF?

Have you been thinking, “Jeez, I really wish I knew what an ETF was.” Probably not. But if you did, this note is for you.

To begin, the acronym stands for Exchange-Traded Fund. It’s an apt name because ETFs are a hybrid of a stock and a mutual fund.

  • Like stocks, ETFs trade on a stock exchange during the business day. Most mutual funds are bought and sold at their end-of-day “net asset value” (NAV).
  • Like mutual funds, ETFs are portfolios of many stocks (or bonds). Most stocks are investments in a single company.

There are small differences between ETFs and mutual funds and these can translate into minor advantages and disadvantages for either one. Consider:

1. With ETFs, you incur two trading expenses each time you trade them — a commission and a bid – ask spread. In most cases, they are insignificant. With mutual funds, you buy and sell shares at the NAV and do not incur either expense.

If you are making regular small investments (for example, ongoing payroll contributions to a 401K or IRA), ETFs are ill-suited as these two expenses will become meaningful over time.

Advantage: mutual funds

2. Both ETFs and mutual funds incur operating expenses. Most ETFs have low operating expenses while mutual funds have a wider range of these fees.

In both cases, the fees are disclosed and there are comparable investment selections with comparable fees for both of them.

Advantage: neither

3. With ETFs, you can trade them whenever the stock market is open. With mutual funds, the transaction is always done as of the end of the trading day.

In theory, this is an advantage for ETFs; but in practice, most investors should avoid intra-day trading. You’re more likely to make rash and regretful decisions when offered that opportunity and you probably would have been better off had you done nothing instead of intra-day trading.

Advantage: ETFs (maybe)

4. With ETFs, there is no guarantee that the price at which you buy and sell is anchored to the NAV at that time. However, for technical reasons, any pricing variance should be insignificant. With mutual funds, you always buy and sell at the end of day NAV with no discount or premium.

Advantage: mutual funds (small)

5. ETFs can be more tax-efficient than mutual funds for technical reasons having to do with how capital gains are distributed.

Compared to a well-managed index fund, this effect is likely to be insignificant. And, if you are investing in a retirement account, this is irrelevant as these taxes would not affect you.

Advantage: ETFs (small)

Bottom Line:
For most people in most situations — and especially in retirement accounts — stay with low cost index funds. If your crazy uncle is extolling the virtues of ETFs, tell him that there’s little substantive difference between them and low cost mutual funds.