At Premier Financial Group, our advisors sometimes hear questions about ETFs. What does the acronym "ETF" stand for? (Exchange-traded funds). How many ETFs are there? (Thousands.) How many U.S. households hold ETFs? (About 5 percent as of 2013).
With those "easy" questions out of the way, let's focus on the meat of the issue: What differentiates ETFs and comparable index funds? That's a bit more complex. Read on to learn what you need to know about ETFs.
ETFs, Index Funds and Your Comprehensive Financial Plan
Both ETFs and index funds invest in hundreds, or even thousands, of stocks and bonds, providing diversification for portfolios. However, unlike index funds, ETFs are traded on major stock exchanges, so their prices may fluctuate throughout the trading day. Index funds are priced just once per day, at the close of the market. Investors may buy or sell ETFs through a brokerage account, while index funds can usually be purchased directly from the fund "family."
Another significant difference? ETF transactions usually come with higher fees and costs than index fund transactions, and investors generally pay the difference between the lowest seller's and the highest buyer's price, a.k.a. the bid-ask spread. When investors purchase ETFs, they pay the asking price. When investors sell ETFs, they receive the bid price.
Additionally, many investors pay a commission when purchasing ETFs. A few brokerage firms offer commission-free transactions on particular ETFs, but be aware that that many firms only offer commission-free trades on their own sponsored products. While index funds allow investors to automatically roll over dividends, this isn't an option with ETFs. Finally, minimum investment thresholds are generally higher for index funds than for ETFs.
Wealth Management Consultants Weigh In: Avoid Hidden ETF Costs
When allocated appropriately, ETFs can add to a portfolio. But when used incorrectly, this type of investment can result in hidden costs and fees. For instance, as we mentioned earlier, investors must purchase and sell ETFs through a brokerage account; when you open such an account, you're also opening the floodgates for sales pitches on many other investment products.
Brokers may also attempt to get you to buy, sell or make other investment decisions based on their research, which will usually indicate that a certain sector is outperforming. However, as we've detailed in previous blog posts, we feel that active management is not a good long-term investment management solution.
Are Certain ETFs More Risky than Others?
In a nutshell, possibly. Some ETFs are quite narrow, containing holdings across a limited range of sectors. If you invest in narrow ETFs, you're betting that sector will outperform.
Leveraged and inverse ETFs may represent additional risk. Leveraged ETFs attempt to amplify returns of the index they track by matching invested dollars against invested debt. However, management and transaction fees quickly eat up any theoretical gains. Similarly, inverse ETFs actually gain value if the index they're tracking declines. Drawbacks of these non-traditional ETFs may include:
- Higher risk
- Higher costs
- Lower tax efficiency
When appropriately used, ETFs can be a valuable piece of your portfolio. Options such as low-cost, global stock index funds and bond ETFs that include both the international and domestic bond markets may offer solutions.