Doing a little shopping for your portfolio this season? Perhaps you should consider exchange-traded funds as a lower-cost route to pursuing your investing objectives.
But before you jump in, take a moment to do a bit of window-shopping and assess the fit, style and value.
ETFs are baskets of securities that typically track a sector-specific, country-specific, or a narrow- or broad-market index and are thus considered to be passively managed (someone isn’t actively choosing which stocks to buy and sell). They list on an exchange like a stock so you can conveniently trade them through your brokerage account. And ETFs can offer some potential benefits as well:
- Diversification. With ETFs, you can distribute investments across sectors, sub-sectors and asset classes. You can target specific indices, commodities or international markets.
- Potential income. Many ETFs have historically paid dividends, so some investors choose ETFs as an alternative, or an addition, to other income stocks. But, remember the continuation of these dividend payments is never guaranteed.
- Potential tax benefits. The tax implications on ETFs can be complicated and vary depending on the asset class and structure, but in general, an ETF investment isn’t taxed at the investor level until you sell it. Mutual funds, in contrast, incur a potentially taxable event, each time a security is sold, and capital gains may be passed through to the investor level (see Value—taxes and turnover section below). But remember: taxation can be dependent on how long you held an ETF. Speak with your tax advisor on your specific circumstance.
Comparison Shopping: ETFs and Mutual Funds
What features do mutual funds and ETFs have in common and what are the differences? This table might help you get a better sense.
|Diversified offerings, including the chance to expose your portfolio to a variety of sectors including "value" or growth as well as international exposure.||Yes||Yes|
|Ability to trade like a stock.||No||Yes|
|Offers a more passive managing approach and potentially lower expense ratios.||Sometimes, depending on the fund||Most of the time|
|Imposes various fees.||Yes||Yes|
|Gives a daily update of all the shares or other investments held by the fund.||No||Yes|
|Managed by professionals.||Yes||Yes|
|Same order types available as for individual stocks.||No||Yes|
|Tracks minute-by-minute trades as the market moves.||No||Yes|
|Net asset value determined by the total value of the underlying assets, minus fees, divided by the total number of shares.||Yes||Yes|
As You Shop: Comfort, Style, Value
When you hit the shopping mall, say to buy a new suit, dress or pair of shoes, you likely look at three things—style, comfort and value. Shopping for an ETF involves pretty much the same considerations.
- Comfort level—risks. The risks of index ETFs are typically the same percentage risks as the indexes they track. The risks of sector-based ETFs depend on the basket of stocks they track, including the weighting of each stock. Because you can choose broad-based indexes or narrower industry choices, index and sector ETFs can be a starting point for some investors.
- Comfort level—complexity. ETFs have gotten more specialized—some would say more complicated—over the years. Experienced investors might consider “hybrid” ETFs that are leveraged, inverse, sometimes both. Special risks are associated with these funds. Before trading these very distinctive products, be sure to learn the risks, and keep in mind that most of these are intended for very short holding times, often as short as one day.
- Style—active and passive. Contrary to some thinking, ETFs can be a good fit for active market participants too; they can be shorted, hedged (with an offsetting position), bundled (buying several at one time as a potential cost-saver) and many have options traded on them. They sometimes bring less volatility than individual stocks, yet potentially more flexibility than mutual funds. Active traders might consider ETFs as a diversifier to help deal with potential “surprises” that can accompany trading individual issues of stock.
- Value—taxes and turnover. By construction, ETF investors may have less exposure to capital gains taxes than actively managed mutual fund shareholders. That’s because mutual fund managers frequently buy and sell the fund’s holdings, ideally at a profit, and pass along those tax obligations to shareholders. ETFs occasionally move shares around, too, although much less than most managed mutual funds. Annual expenses for ETFs range between 0.1% and 0.65%, according to fund-tracker Morningstar, Inc. Index mutual funds tend to charge anywhere from 0.1% to an average 1.5% (the high end reflects actively managed), according to the Investment Company Institute.
- Value—transaction costs. ETFs aren’t for everyone and certainly, not every situation. For instance, no-load mutual index funds might be a better fit than ETFs if you prefer dollar-cost averaging. That’s where you build up a portfolio slowly and in pre-set increments. ETF trading costs could pile up, eating up your potential profit, if using such a strategy. For instance, the transaction costs associated with buying one share at a time can be prohibitively high.
A Few Shopping Tips
As you look through the universe of ETFs for candidates, you'll want to look at key metrics for each fund you're considering—performance statistics, ratings and expense ratios, to name a few. But it may also help to know yourself—your investing objectives, time horizons and risk tolerance. Here are a few things to consider:
- Determine what you're investing for.
- Is your investment style: conservative, aggressive, or somewhere in-between?
- Are you investing for short, intermediate or long-term?
- Are you diversifying your portfolio by incorporating various sectors, asset classes, & markets?
- Are you looking for an alternative way to enter the market?
- Do your research.
- Take advantage of the tools & resources offered by most providers.
- Look at historical performance, analyst reports, and screeners.
- Be mindful of fees.
- Look at expense ratios within the actual funds.
Time to Hit the Market?
The TD Ameritrade ETF Market Center provides one of the broadest collections of ETF research tools, third-party market insights/analyses, and ETF products out there. And, it's home to a newly-expanded list of 296 commission-free ETFs, which can provide you with a wide range of low-cost investment opportunities.
Carefully consider the investment objectives, risks, charges and expenses before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.