Exchange-Traded Funds

A 60-Second Guide

The "It" equity -- the exchange-traded mutual fund -- is no spring chicken. It's been around since the early 1990s. But ETFs are still turning heads. It's no wonder: The combination of index investing with the handiness --- and lower costs -- of individual stock ownership is irresistible. Are ETFs a good match for your portfolio? Read on...

0:60 Consult your investing dictionary.

What exactly is an exchange-traded fund (ETF)? "Exchange-traded" refers to shares that trade all day long on the major stock market exchanges (just like regular stocks). "Funds" are investing vehicles that hold dozens, hundreds, or even thousands of companies under one umbrella unified by a particular investing theme (such as companies that comprise the Dow or ones whose main business is in the biotech industry). Like any other publicly traded company, ETFs have ticker symbols (snappy ones, in fact, like Cubes, Spiders, and Diamonds). But instead of typing "MSFT" to buy Microsoft, for example, you enter "DIA" for the Dow Jones Industrial Trust, or "Diamond" ETF. Do you need diamonds in your portfolio?

0:54 Poke holes in your portfolio.

Do you crave exposure to foreign indexes? Are your holdings a little heavy in large American companies? Do you think biotechnology is a boom industry, but aren't comfortable committing money to one particular company? There are ETFs to represent virtually any segment of the market -- both here and abroad -- nearly any way you slice it. There are ones tracking everything from bonds, REITs, and the utility sector to the pedestrian Fool favorite S&P 500. If that sounds a lot like the index mutual fund market's offerings, it is. For some investors, though, ETFs are a better fit for their investment dollars.

0:47 Get a little Zen.

Time for some soul-searching. Don't worry -- not the touchy-feely kind. Are you a "feet first" kind of investor, or do you prefer to build your portfolio slowly? If you'd like to add an indexing element to your portfolio and are prepared to invest a lump sum, ETFs provide some flexibility you might find useful. Like regular stocks, they can be bought or sold anytime the market is open via your brokerage account. (Traditional index funds, on the other hand, can only be redeemed at the closing price of each day.)

If you plan to dollar-cost average (adding small, systematic amounts to build a portfolio), ETFs aren't ideal. They don't offer direct investment programs, so dollar-cost averaging would rack up trading costs that far outweigh any cost benefit over a traditional index fund. For you, a more efficient route would be a no-load, low-expense index fund.

The mutual fund-ETF face-off isn't over quite yet, Grasshopper. Before you click "buy"...

0:34 Check out the competition.

They may track the same stocks and offer easy diversification -- but subtle differences between index funds and exchange-traded funds can affect your long-term returns:

  • Taxes: The big buzz about ETFs is their tax efficiency. The big "tax event" for ETF shareholders happens when you sell your shares, hopefully at a profit, after which you'll pay capital gains taxes.
  • Expense ratios: By construction, ETF investors have less exposure to capital gains taxes than mutual fund shareholders. That's because fund managers frequently buy and sell the fund's holdings -- and ask investors to pick up the tab. ETFs occasionally shift shares, too, although much less than most mutual funds. Annual expenses for ETFs range between 0.1% and 0.65% and are deducted from dividends. Index mutual funds charge anywhere from 0.1% to more than 3%.
  • Minimum investment requirement: For investors with limited funds (say, less than $1,000) who want to get started in the stock market, ETFs offer a cheap entrée. Through your discount brokerage account, you can buy one single measly share if you choose. In comparison, many index mutual funds have high initial balance requirements. (Those with lower requirements often charge higher fees.)
  • Ease of use: Here's the double-edged sword of ETF investing. They are easy to buy -- you simply need a discount brokerage account (and that's easy to get -- and cheap). Consequently, they're easy to trade. And trade and trade and trade.

Don't be blinded by love based on low expense ratios and minimum investment requirements. There's still a price to pay to invest in ETFs -- mainly brokerage fees. And there's the rub...

0:19 Keep fees in check.

As a stock, ETFs can be optioned, shorted, hedged, and bundled. We don't like the idea of investors trading in and out of ETFs repeatedly, or going on margin to the hilt to buy them, any more than we do any other stocks. Like traditional index funds, ETFs are best used as a long-term investment tool. The best investing strategies for most investors are the simplest ones -- filling asset allocation gaps and replacing higher-fee mutual funds.

If you want to get fancier than that, ETFs can accommodate more advanced investing tactics (we go into in more detail here). But tread lightly: Don't rack up trading commissions or capital gains taxes by actively trading.

0:08 Do a background check.

And finally, as with any investment, make sure you get what you're paying for: means scrutinizing an ETF's holdings as you would those of any mutual fund before you buy. It's not only individual investors enamored with this newfangled investing vehicle -- the industry's keen on them, too, and getting a little loosey-goosey with labels. So make sure the ETF label matches the underlying securities you want to buy before heading off into the sunset, hand in hand.

Got another minute?

  • How ETFs Became the "It" Equity: Exchange-traded funds have attracted trillions of investing dollars. Here's how they snuck onto the scene and why the fund world is on notice.
  • Mutual Funds vs. ETFs: In a side-by-side taste test, which comes out ahead? It depends on who's doing the math.
  • Investing Strategies: They're nimble and can accommodate an array of investing techniques. But the best strategy is probably the simplest.
  • Potential Pitfalls: Don't be tricked into buying an ETF impostor. Here's how to avoid this and other potential trip wires.

Next: ETFs: The "It" Equity? »


Read/Post Comments (49) | Recommend This Article (463)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 28, 2009, at 4:35 AM, wrkdiver wrote:

    Does anyone know how I can find an ETF with Brazilian Bonds?

  • Report this Comment On December 08, 2009, at 9:44 PM, sniren wrote:

    Congratulation you have described

    the ETF very good I have some positions.

  • Report this Comment On February 24, 2010, at 12:49 AM, eileen1023 wrote:

    I WANT TO BUY SILVER AND BUY THROUGH AN ETF. hOW DOES ONE GO ABOUT THIS

  • Report this Comment On February 26, 2010, at 10:21 PM, ITAWealth wrote:

    You can use the SLV ETF for your silver purchase.

  • Report this Comment On February 26, 2010, at 10:22 PM, ITAWealth wrote:

    Use SLV for your silver ETF purchase. The process is identical to purchasing a stock.

  • Report this Comment On March 23, 2010, at 4:16 PM, DANSHOE wrote:

    Hi i'm new to investing and as I reside in Europe I wonder if any reader can advise on the best starting investment strategy?

    Q1; Whats the best etf on the LSE to invest in?

    Q2;Would investing in some of Dave or Tom's core stocks be a good initial starting investment?

    Thank you,

    Danshoe

  • Report this Comment On April 06, 2010, at 12:01 AM, ChilamBalam wrote:

    OK but maybe NOT precious metal ETFs.

    Check out the information re SLV or GLD ETFs. Does the ETF represent ownership in physical metal? If so is it a 1:1 correlation (ex 1 ETF = 1 oz or fraction)?

    Reduce your risk and save money, buy the underlying metal from reputable dealers!

    See: Is Your Safe Haven a House of Cards?

    By Christopher Barker April 5, 2010

  • Report this Comment On August 04, 2010, at 4:02 PM, glenrgraham wrote:

    ETF's can be risky and volatile. I do not currently own any. I am interested in Ishares (EWZ) Latin America (Brazil) averages 20% return over last 3 years. See link to the top foreign traded funds and rate of return here: http://finance.yahoo.com/etf/browser/mktk=9&c=0&f=0&...

  • Report this Comment On August 23, 2010, at 10:12 PM, MissChoudhry wrote:

    Why do you think ETFs have lower expense ratios than traditional index mutual funds? Why do index mutual funds have lower expense ratios than managed mutual funds?

  • Report this Comment On August 27, 2010, at 11:48 PM, glenrgraham wrote:

    Correction I now own some Ishares (EWZ) Latin America (Brazil) - I am hoping that it will perform. I also got some YUM since they are a good fast food restaurant stock expanding in China - sort of a global franchise.

  • Report this Comment On September 01, 2010, at 11:22 AM, genenoel wrote:

    Is there a ETF that is heavy in Ford stock?

  • Report this Comment On October 16, 2010, at 5:22 PM, pengthom wrote:

    I recently found out that some discount brokerages offer a few ETFs at no commission, is this too good to be true? Why would they offer that?

  • Report this Comment On October 18, 2010, at 1:13 AM, syrasen wrote:

    The different types of mutual funds

    If you want to buy a mutual fund, you have some choices to make. It’s kind of like the 50 kinds of toothpaste you can choose at Target. Except there are thousands of funds and we’re talking about your life savings. Anyway, you can pick a mutual fund of almost any imaginable type, based on many factors. For example, you could invest in a value fund, an emerging-markets fund, or a medical-device fund.

    http://www.guidetoinvest.net/

  • Report this Comment On October 18, 2010, at 1:31 AM, ChrisFs wrote:

    "Through your discount brokerage account, you can buy one single measly share if you choose. In comparison, many index mutual funds have high initial balance requirements. (Those with lower requirements often charge higher fees.)"

    This is an expensive way to get into ETFs. Paying a commission (even a discount one) to buy just one share would equal paying a fee of 4-5% (or more) to own that fund. Something you would never recommend for a mutual fund. There are a number of mutual funds with a limit of $500 or less if you open an IRA or Roth IRA.

    Also avoid leveraged ETFs (ones that pay 2-3x times the daily return of an index), due to how they are set up, they will consistently lose money in the long term.

  • Report this Comment On October 22, 2010, at 5:50 AM, jsprack1307 wrote:

    What is the symbol for buying a GOLD EFT?

  • Report this Comment On November 08, 2010, at 10:56 AM, modeltim wrote:

    Physical gold ETF is GLD

  • Report this Comment On December 03, 2010, at 1:45 PM, jmpd2010 wrote:

    I have read that there should be a low turnover rate for mutual funds -- preferably no higher than 50% and hopefully much lower. For index funds turnover can be around 5% or lower. Why is high turnover for ETF's ok?

  • Report this Comment On December 21, 2010, at 11:26 AM, kydderr wrote:

    to the above: UNWPX and/or UNWPX. Both hold the precious metals.

  • Report this Comment On December 21, 2010, at 11:27 AM, kydderr wrote:

    that is USERX - sorry.

  • Report this Comment On December 28, 2010, at 1:27 PM, h53echo wrote:

    I'm going to invest in 529's for my kids and would like some suggestions about ETF's and Vanguard no loads for them.

    I am a retired VP of a major international wirehouse and do my own investing very successfully. However, the kids will be starting with $500 each and my investments won't work for them as they are international EWZ and IFN or heavy in tech BIDU,AAPL, INTC,CSCO,TLEO,GOOG,IBM,FVIII. Also, some GORO.O,AXU,BHP,NOV, and JAZZ. So they are too risky individually.

    Any suggestions?

  • Report this Comment On February 13, 2011, at 5:06 PM, UFOFred wrote:

    Regarding ETF's and brokerage fees --

    If you buy a Vanguard ETF through a Vanguard brokerage account, they charge ZERO. (I just bought their emerging markets fund via a limit order and the charge was $0.)

    Also, Vanguard recently reduced their trading fees considerably depending on how much you have invested in Vanguard funds (including ETF's) -- it is not hard to get several stock trades @ $7.

    Unfortunately, they have not (yet?) reduced their fees for trades on options. If you want to sell covered calls, they charge at least $31.50 -- which kills the advantage of selling calls.

  • Report this Comment On March 20, 2011, at 12:12 PM, busterbuddy wrote:

    concur totally with ufoFred.

  • Report this Comment On April 29, 2011, at 6:52 PM, xetn wrote:

    padafool:

    You seem to only look at existing nuclear power plants and their old technology. We could be recycling spent fuel rods, but the current regs do not allow it.

    You also overlook the problem of making solar panel, it is a very dirty process. You also overlook what happens when you have to dispose of batteries after they no longer hold charges.

  • Report this Comment On May 25, 2011, at 8:57 AM, jakezyrafa wrote:

    Excellent broker for ETF funds is DIF BROKER

    http://www.difbroker.com/web/en_gb/dif-freedom

    1200 ETFs

  • Report this Comment On August 17, 2011, at 11:40 PM, dveikus wrote:

    How does one go about determining what's a better etf? Do financial ratios and the like, which are integral for company picking, play a role? What else, besides reviewing the holdings of a company? Is there a way for an etf to just go bust, if the stocks it holds don't? Thanks.

  • Report this Comment On October 21, 2011, at 11:24 AM, TonyFavero wrote:

    For those interested in a particular mutual fund, but would prefer an ETF instead, use the link below to engage a search for a mutual fund to ETF converter.

    Put both up on a graph to verify how well the ETF tracks against the fund......used if myself many times.

    http://etfdb.com/tool/mutual-fund-to-etf/

    Good Investing.

  • Report this Comment On October 25, 2011, at 5:43 AM, kregly999 wrote:

    I have been buying up as much as I can as fast as I can until I hit my portfolio percentage. Blackrock enhanced dividend trust (BDJ) invests in large cap dividend paying companies. Exxon and Chevron are just a couple of examples. It pays a 9%-11.5% dividend and as the market fluctuates capital appreciation is another big plus. I just started buying this ETF about a month ago at $7.11 a share. The 52 week price range is in the area of $6.25 to $12. If there is an ETF with minimal risk I got to believe this is it. Do your research and I bet you will agree.

  • Report this Comment On October 28, 2011, at 10:17 AM, trejz wrote:

    Why is it that those trying to sell ETFs say the same thing every time, that it gives exposure to foreign indices? All of the ETFs I have, PGJ, EPI, etc. act entirely independent of the foreign exchange they are supposed to be following and instead take ALL the cues from the US market. At this moment, for instance, Asian markets closed UP 1.7% and yet PGJ is down slightly. Yesterday, EPI went up close to 6% because the US market blipped, while a fund I have (EMGIX) that monitors India's market went up just 1.5%. If ETF's monitor stocks that are also traded in the US markets, they do not expose a portfolio to other markets, nor diversify.

  • Report this Comment On November 22, 2011, at 6:00 PM, cindalita51 wrote:

    In response to "h53echo"

    I have 5 children and wanted high yield investments for their accounts, and also jr. gold miners under $3.00 that I had done extensive research on.

    I started buying stocks...not ETF's for them due to the capital gains tax. I started w/ 3 stocks in their portfolio:

    1) (PM)

    2) (MO)

    3) (T)

    4) (VZ)

    5) (ATVI) At the request of my Son.

    6) (PZG)

    If you want to buy them an ETF....the (IAU); which is similar to the (GLD), performed better 3mon., YTD, and 3yr. And it's more affordable than the (GLD,SGOL, & SLV)

    I don't think you can ever go wrong with Jr. GoldMiners....Here are a few of my favorites:

    (KMKGF, TKRFF, EXLFF, AUNFF,CLASF, & ORXIF).

    I just bought the (FXA) b/c they pay a 4.65% yield, but it is an Australian currency & is quite expensive!

    Hope this helps you..................

  • Report this Comment On March 05, 2012, at 6:38 PM, MelFund7 wrote:

    I'm new to investing in ETFs. I'm looking for small-cap and large-cap dividend paying Value ETFs. Where should I start my research...any advice will be well appreciated.

  • Report this Comment On March 21, 2012, at 4:27 AM, sickafus wrote:

    Yes Vanguard ETFs are traded free if you are an admrial, or a flagship client, and you get 25 free stock trades when you become either.

    Might want to look at STWA Symbol (ZERO) http://stwa.com/technology.cfm I purchesed a bunch a while back at 20 to 30 cents, its now trading at 60 to 70 cents, might explode?

  • Report this Comment On April 21, 2012, at 5:20 PM, OkieOilman wrote:

    Does anyone know the NFC stock David was referring to in a previous e-mail regarding doing away with credit cards and using smart phones instead? I think joining this group will be very helpful in my investing. Info is stellar!! Thanks all.

  • Report this Comment On April 28, 2012, at 2:04 PM, mick1key wrote:

    I have so many stocks in so many different companies,,I think I am a ETF..no big amts 5 and up..no theme..trying to cover all bases..love the hunt and when you hit a winner its the best feeling..

  • Report this Comment On July 15, 2012, at 1:16 AM, jajk wrote:

    I just heard about an ETFs that will gain money as the US inflation starts in two months, so that while inflation and the interest rates go up the ETF will be making money. The other is an ETF in Europe that is poised to make money as the Euro is replaced by a return of country currencies. Does anyone have a name for those to ETFs?

  • Report this Comment On August 18, 2012, at 12:02 AM, GeauxLong wrote:

    jajk,

    You're thinking of inflation protected treasuries called TIPS. They adjust to the inflation rate.

    Search for "inflation protected ETF" or "TIPS ETF" and you'll find more information about them.

  • Report this Comment On January 19, 2013, at 12:23 PM, heliskiier wrote:

    Here are a few that have tremendous upside. Send me a note if you wanna know why. EWA (Australia), Australia has little of the economic problems we have and they supply China in a big way. PKB (Biotech), Uranium.

    Australia has been on a huge run and it still has huge upside.

    Biotech is beaten down and has carved out a bottom and is on an upside now.

    Uranium is also hated, but the global nuclear situation provides massive upside.

    GDX and GDXJ are great when gold starts to break out of it's consolidation an both are beaten down now.

    Oh, and there is one MLP out there that is going to explode. Ticker is OKS. Research them and make your own decisions. All of these have been excellent performers for me.

  • Report this Comment On February 25, 2013, at 12:54 AM, dougthefool100 wrote:

    I understand what the ETF is buying i.e. sector related stocks - either bullish or bearish . What does the , " 3X " in the description of some , indicate .

  • Report this Comment On March 29, 2013, at 7:45 PM, hegibson wrote:

    The need to reform healthcare should be a no-brainer. But how it should be done is the monumental question. I have lived in three countries with different delivery systems. (US, Australia and Canada) No surprise that there would be an aggressive push back against a public system from the "for profit" stakeholders: insurance companies, hospital corporations and doctors. Businesses never thought that they would become major healthcare providers. Under the present US system the cost is only going to go up exponentially unless something is radically done. Obamacare in theory was an attempt to control increasing costs in the least disruptive way. It tries to walk both sides of the road. Unfortunately that approach only angers most parties. None of the stakeholders are going to give up that easily. As with many things in the US what to do with healthcare is no less political and divisive. Of the three systems I have experienced I think that the Canadian system is the best. Businesses do not have to be healthcare providers. They do not have to allocate funds or hire people to administer healthcare services. No one is without access to decent healthcare. Yes it is delivered in a different way but my family has experienced it firsthand for serious illnesses and have been very pleased with the care that we have received. Is the system perfect? No human system is. But it is less costly that the US, it is more compassionate than the US (everyone has access) and it is not a drain on businesses just to name a few benefits. Most everyone pays something in this system in some way. Insurance companies, hospital corporation and doctors are not going to set limits upon themselves, ever, they are in it to make a profit and make a profit off of other people's misery. That is why government should step in and revamp the whole system. I don't think that the present US politicians would ever have the backbone or foresight to do the radical surgery to the system (pun intended) to control the cost of healthcare. Not everyone agrees, but I more and more see healthcare as a basic need, like food, shelter and clothing, rather than a luxury option.

  • Report this Comment On May 21, 2013, at 10:15 PM, edginuity wrote:

    Question . . . What is a good site (fee or not) to get sortable ETF performance data for a given past date? For example, I'd like to identify the top performing ETFs for the week, month, & year prior to some past date. Any suggestions? THANKS

  • Report this Comment On May 30, 2013, at 9:18 PM, garrah wrote:

    You might try midnighttrader.com or marketedge.com, not sure you may be interested but AMD chip maker is going to be SOLE source of gaming consoles soon,,,

  • Report this Comment On July 30, 2013, at 3:24 PM, mloria wrote:

    What are the main differences (pros/cons)between an Index fund and an ETF.

  • Report this Comment On October 21, 2013, at 9:31 PM, monafifi wrote:

    Am new can i get some help

  • Report this Comment On March 26, 2014, at 8:41 AM, pastor27 wrote:

    Hello, Motley Fool members and other investors

    I am in a state of shock and feel like I have been robbed and beaten at gunpoint. I WANTED TO WARN ALL OTHER INVESTORS of this ETF/YCS situation.

    Although it is UNBELIEVABLE, I am going to be taxed on $12k of income WHEN I ONLY RECEIVED $4k in total gains!!

    I purchased the ETF YCS (ProShares UltraShort Yen). I may have been warned about tax complications, but I DID NOT EXPECT THIS! This fund is set up as a partnership. I received a K1 that reported $8k flow-through income THAT I DID NOT RECEIVE!! I made about $4k in my options and YCS trades, but by the time I pay taxes on $12k (adding the $8k that I didn't get and will NEVER get), I will barely make any money at all on my YCS trades. I still can't believe I'm being taxed on money I will never get, but that's what CPA's are telling me!

    If you are going to purchase an ETF - MAKE SURE YOU UNDERSTAND IT and that they will report any gains to you on a 1099 and NOT a K1!!

    AVOID Proshares (EUO, YCS), Blackrock (GSG), Invesco Powershares (DBC DBA), US Commodity Funds (USO, UNG) for starters!

    Blessings,

    Greg

  • Report this Comment On March 28, 2014, at 5:20 PM, SteadyDIme wrote:

    Thanks Greg / pastor27 for highlighting the Income Tax problems that K-1 distributions can create.

    If anyone wants to trade these these types of investments, it is best to do so in Retirement Accounts, rather than taxable accounts.

  • Report this Comment On April 19, 2014, at 11:55 AM, kolly7 wrote:

    i hereby want my account to sign up okay

  • Report this Comment On July 01, 2014, at 5:45 PM, gillnose wrote:

    I own ixp, a telecommunication etf. I just received my semi annual dividend of $6.37/share! I researched past June distributions and found none higher than $1.72/share. I looked for any news release or press statement to explain the jump but found none. Can anyone help to explain how this huge jump occurred?

  • Report this Comment On August 08, 2014, at 1:13 PM, jessievera wrote:

    I worked at a currency exchange center in the airport for a few years and I loved that job. I learned so much and gained a lot of experience. I was able to meet meet from all over the world and hear about all the different places they were all traveling to.

    Jessie | http://www.rmcoin.com/currency/

  • Report this Comment On August 13, 2014, at 11:38 AM, nwfl890 wrote:

    Where would I find information on Motley Fool about using ETFs to diversify IRA accounts?

    Should I diversify the Roth first or the Contributory IRA first?

  • Report this Comment On September 13, 2014, at 7:06 PM, MagyarCs wrote:

    all you want to know about ETFs: http://etfdb.com/

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