Exchange-traded funds are a fast-growing alternative to mutual funds that many investors know little about. Here’s a look at ETFs, and when they make sense for individual investors:
WHAT THEY ARE: Funds that invest in a basket of stocks or bonds and track an index or sector. They trade on the major exchanges and can be bought and sold like stocks. They’re available for broad U.S. and foreign indexes as well as for industries and other sectors, mimicking everything from alternative energy stocks to gold to currencies.
HOW THEY STARTED: The first U.S. fund was the Standard and Poor’s Deposit Receipt, created in 1993 by State Street Global Advisors in partnership with the American Stock Exchange. The SPDR, or “spider,” gave investment banks and pension funds an easy way to track the S&P 500 without buying an index fund. The SPDR S&P 500 ETF, known by its ticker SPY, remains the largest of about 1,100 U.S. ETFs, with $84 billion in assets.
BIGGEST ETF PROVIDERS: The top three providers in the U.S., measured by ETF assets, are iShares, State Street’s SPDR ETFs and Vanguard.
PLUSES: Expenses are lower than for regular index mutual funds, in many cases. They can be bought or sold during the trading session, allowing investors to make transactions without having to wait for the closing price as with mutual funds. They’re tax-efficient because they come without the required distribution that can saddle mutual-fund investors with annual capital gains taxes.
MINUSES: Fees for each transaction, although that is changing. Several major discount brokerages now offer commission-free trades for select ETFs through their brokerage platforms. Some newer ETFs track extremely narrow slices of the market, making them riskier. You can’t beat the market or a sector with an index, you can only match its results.
CONSIDER AN ETF IF: You want lower taxes than a mutual fund by avoiding taxable distributions. You want the lowest-cost fund option, which is often an ETF. You trade actively, so you can potentially take advantage of price changes during the trading session. Or you want exposure to a market niche that isn’t covered by an index mutual fund (ETFs outnumber index mutual funds by more than 2 to 1).
CONSIDER AN INDEX FUND INSTEAD IF: You’re making small, regular investments. The index fund may have lower annual operating expenses than the equivalent ETF. Or the ETF is thinly traded.