You can't argue with exchange-traded funds' success. ETFs have existed for little more than a dozen years, yet they've already gathered assets of $440 billion. Last month alone, $9 billion flowed into ETFs, indicating that investors increasingly recognize these offerings' advantages. ETFs are an improved and updated version of a great product, the mutual fund, which clearly needed a makeover after 80 years on the market. ETFs have so many advantages when compared to a traditional mutual fund that there's really no contest:
- ETFs have no minimum investments.
- You can trade ETFs any time the market is open.
- ETFs have low fees.
- You can use ETFs for short-selling on both an uptick and downtick.
- ETFs are tax-efficient.
- Investors can buy ETFs through a regular brokerage account.
- ETFs are scandal-free.
Unlike traditional mutual funds, which sometimes require initial investments of thousands of dollars, ETFs can be purchased one share at a time. The iShares S&P 100 Index ETF (AMEX: OEF ) , for example, trades at around $70 a share. For just $70, an investor can get instant exposure to a broadly diversified group of 100 blue chip stocks.
ETFs offer continuous liquidity, since they're available for trading on exchanges during market hours. Traditional mutual funds can only be bought or sold once a day after the market has closed. In addition, some ETFs can be used as proxies for entire industry sectors, making them far more efficient trading vehicles for investors seeking exposure to a particular sector. For instant diversification and lower risk and volatility, ETFs are the investment of choice.
ETFs generally have low expenses -- as little as 0.07% for the Vanguard Total Stock Market ETF (AMEX: VTI ) . Mutual funds, on the other hand, can run expense ratios of 2% or more. Low expenses translate into stronger after-fee performance, significantly boosting long-term returns.
Like individual stocks or mutual funds, ETFs can be used for short-selling. However, ETFs have an additional advantage: You can short an ETF even on a downtick, which is prohibited on individual stocks. Also, if you're not allowed to do short sales in your retirement accounts, you can still use ETFs whose prices move inversely with market indexes.
If you own traditional mutual funds, you've probably dealt with the unpleasant task of paying tax on annual capital gains distributions. Taxes aren't just painful -- they chew away at your investment returns. Because most ETFs have low turnover rates, they don't have to distribute nearly as much in capital gains.
Brokerage account trading
All you need to trade an ETF is a brokerage account. You don't have to write letters to purchase or redeem shares; trading ETFs is as simple as buying or selling stocks.
Forget the scandals
Unlike their mutual fund cousins, which have faced numerous scandals for the past half-dozen years, ETFs have remained scandal-free. That's because ETF prices can immediately adjust to any discrepancy in value. Additionally, ETFs are more transparent than mutual funds; each ETF's portfolio is widely available, while traditional funds disclose their portfolios only a couple of times per year.
ETFs can help investors construct a broadly diversified portfolio with only a handful of investments and very little capital. They're not only easy and cheap to buy and sell, but they also offer significantly lower long-term expenses to hold in the average portfolio. Because of their flexibility, ETFs can be used in a broad array of strategies, from commodities to foreign currency and private equity. Their low overall expenses and market performance make ETFs the clear winner over traditional mutual funds. The new generation of funds is here, and they're a truly innovative improvement on a classic.
Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or securities mentioned in this article. The Motley Fool has a disclosure policy.