An Exchange-Traded Fund (ETF) is a special type of mutual fund product that has all the advantages of a mutual fund, plus it can be traded like a stock. But is that an advantage? Learn the pros and cons of ETFs and why they are controversial. Just as traditional types of mutual funds include both actively-managed funds and passively-managed funds, the same is true for exchange-traded funds (ETFs). We focus our attention on exchange-traded index funds because active management is a loser’s game—for ETFs as well as traditional mutual funds. Contents:
Select Video Tutorials about Exchange-Traded Funds (ETFs)
Playlist for Exchange-Traded Funds:
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Playlist for ETFs by Khan Academy:
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All are excellent videos. The transcripts can help you make best use of your time.
Commonly asked questions about ETFs
Commonly asked questions about Exchange-traded funds (ETFs)
- 1 What is an ETF?
- 2 How do ETFs work?
- 3 Are there any problems with ETFs?
- 4 Should I use mutual funds or ETFs?
- 5 How should I place orders to buy and sell ETFs?
- 6 Is an ETF like a closed ended mutual fund?
- 7 Do ETFs have a tax advantage?
- 8 Why doesn’t John Bogle like ETFs?
Answers to questions about exchange-traded funds (ETFs)
1 What is an ETF?
Main article: What are ETFs? (video)
In short, it’s a security that divides ownership of a large collection of stocks or bonds into shares that investors can buy and trade on an exchange like a stock. It’s like a mutual fund, but instead of investors buying and selling shares from the fund itself, investors trade their shares on an exchange with other investors—exactly like they would trade individual stocks. For long-term investors there is essentially no difference between a good ETF and a good mutual fund.
2 How do ETFs work?
See also: What are ETFs? (video)
If you wanted to buy shares of stock in 500 largest companies, you could either do 500 different individual stock purchases (expensive) or simply ask your broker to purchase a single share on an ETF that tracks the S&P 500. It’s that simple. The value of the ETF will rise and fall with the stocks within that collection. And there annual expenses to manage this is very low and similar to the best mutual funds. The reason they’re cheap is because you are taking away the fund manager.
3 Are there any problems with ETFs?
See also: What are ETFs? (video)
Just like buying and selling individual stocks, there are transaction costs with ETFs. This includes broker fees and the bid-ask spread costs. This makes them less appropriate than low-cost mutual funds if you are making monthly contributions (say, to save for retirement) or monthly withdrawals (say, to spend during retirement). Buying and holding an ETF for the long-term is equivalent in cost and risk as owning the same securities in the form of a mutual fund.
4 Should I use mutual funds or ETFs?
It is also easy to find low-cost mutual funds that hold the same securities. I mentioned above that the transaction costs makes them less appropriate than low-cost mutual funds if you are making monthly contributions (say, to save for retirement) or monthly withdrawals (say, to spend during retirement). For first-time investors, the minimum investment of mutual fund must be considered. A typical minimum might be $1,000 or $3,000 — although an investor might get this waived if they sign up to make periodic investments. Or, an investor might simply save in a bank account until the minimum investment can be achieved.
The ability to sell at any time, say in the middle of the day, is often touted as an advantage of ETFs. However, it must be recognized that if the market drops and a panicked investor wants to sell in the middle of the day, there is nobody who can know whether the market might recover during the second half of the day. Being tempted into attempting to time the market is probably a reason NOT to buy an ETF—or perhaps it is an indication that the investor is not holding an appropriate allocation between stocks and bonds.
Investors should buy and hold. If they do, there is little difference between a good ETF and the equivalent broadly diversified low-cost traditional index fund.
5 How should I place orders to buy and sell ETFs?
See also: Limit Orders (Boglehead wiki)
In order to buy or sell an exchange-traded fund (ETF) or stock, you place an order with your broker. The least risky way to place an order for an ETF is to match the best current offer by placing a limit order to buy at the current best offer to sell (or vice versa).
6 Is an ETF like a closed ended mutual fund?
See also: What is an ETF? Part 3 of 3 (video)
Yes, an ETF is very much like the best of open-ended mutual funds (most common) and closed-ended mutual funds.
7 Do ETFs have a tax advantage?
See also: Investing FAQ (Boglehead wiki)
Excerpt: “Most stock ETFs have a potential tax advantage over similar mutual funds. However, Vanguard ETFs have no tax advantage over the corresponding Vanguard index funds, because the ETF is a share class of the index fund and thus the mutual fund shares the tax benefits of the ETF. ”
8 Why doesn’t John Bogle like ETFs?
That’s not accurate. John Bogle doesn’t care whether you own a good ETFs or a good mutual fund if you are a buy and hold investor, as you should be. But he does object the very high amount of daily trading that ETFs enable, or the temptation that they provide to get in and out of the market. John points out that at Vanguard, for investors that invest at least $10,000, the holdings are identical, the costs are identical, and the risks are identical.