Exchange traded funds (ETFs) have become popular with advisors and retail investors because they provide several advantages over individual stocks and mutual funds. Investors may find ETFs to be a complement or alternative to the stocks and mutual funds in their portfolios. Some advantages of ETFs are described below.
Diversification. Diversification means not putting all your eggs in one basket. This is a key investment notion for those who want to reduce risk. An ETF is essentially a basket comprised of stocks or bonds. This feature allows investors to hold a diversified portfolio by simply purchasing one ticker. One ETF may hold hundreds of investments. In addition, ETFs and mutual funds often have specific investment objectives that may emphasize region, sector or market cap size just to name a few.
Lower Costs. ETFs are generally considered passive investment strategies. They aim to replicate an index. Contrast this, to actively managed mutual funds that pay managers to make decisions in hopes of outperforming an index. This is one of the reasons that ETFs generally charge lower expense ratios when compared to mutual funds. For the average investor, using an ETF can also help save on transaction costs. As mentioned above, investors can buy a whole portfolio with just one transaction.
Trades on an Exchange Like a Stock. While ETFs allow investors to buy a diversified portfolio of stocks, they also have the advantage of being exchange traded. This means that ETFs trade like a stock. Investors can buy and sell at prices that are updated throughout the day. Mutual funds, however, update prices once, at the end of each day.
Tax Efficiency Advantages Versus Mutual Funds. ETFs may reduce capital gains tax for investors. Authorized participants may conduct what is referred to as an in-kind transaction. They may redeem shares and receive a basket of stocks representing the portfolio. This is a non-taxable event. Transactions in mutual funds require the buying/selling of the underlying securities, increasing the likelihood of triggering taxable capital gains.
Transparency: ETF issuers must publish their holdings daily allowing investors to see exactly what their ETFs are invested in. Mutual fund companies are only required to do this quarterly. This intermittent reporting means that mutual fund investors may not know exactly what they are invested in for extended periods of time.
Reduced Risk of Style Drift: ETFs own portfolios that follow a passive or active index, usually according to defined rules. Investors can generally be confident that the investment objectives of the ETF are being adhered to. Actively managed mutual funds are not necessarily governed by a set of defined rules. A manager’s discretion regarding investment decisions may lead to a portfolio that differs materially from what the original fund investment objectives set out to accomplish. Some advisors and investors may view the risk of style drift as a reason to use ETFs versus actively managed mutual funds.