On our Investing Beginners discussion board, community member QEtrailboss asked a good question: "Why are so many folks keen on ETFs -- what makes them better than mutual funds?"
She was referring to exchange-traded funds, strange beasts that share some characteristics of both stocks and mutual funds. Several helpful board denizens responded. Here are some of their answers:
- To paraphrase Matt1344: (1) ETFs generally sport lower management fees and no load or exit fees. You do, however, pay commissions on trades. (2) ETFs trade like stocks. You do not have to put in your order and guess what the price will be at the end of the day. (3) ETFs feature less turnover in holdings, which may result in lower tax consequences caused by distributions.
- Member theHedgehog noted, "Well, an ETF is not a mutual fund. A mutual fund is managed by someone who decides on a daily/weekly/whatever basis what he will buy or sell on your behalf. ETFs, on the other hand, are a special [form of or variation on] index funds. If you believe in indexes and prefer stocks over index funds, then ETFs are the way to go. The drawback is that you have to pay brokerage fees to buy and sell. So you don't want to make small transactions. If you keep each transaction above $5,000, then you keep a larger percentage of your own money. Plus, you can buy or sell anytime during the day. I don't think you can do that with a fund." [Note that you can do well with many ETFs investing a lot less than $5,000 at a time. But small sums such as $50 or $200 can generate commission fees that represent too big a percentage of your investment. Aim for no more than 2%, which would be a $20 commission for a $1,000 investment, or a $12 commission on a $600 investment.]
The bottom line is that sometimes, an index fund will serve you just fine. And other times, ETFs may be best. It also depends on the index fund you're looking at, and the ETF. When comparing any two, one may have a significantly lower expense ratio, which is the annual fee you'll pay, expressed in percentage terms. Even small differences can make a big difference in the long run. Another consideration is how much money you can start your investment with. Some index funds require an initial investment of $1,000 or more. If you have only $500 and are itching to start, an ETF might do the trick.
A great beginning ETF is the Spider (AMEX:SPY), based on the S&P 500. If you're looking for international investments, consider the iSharesMSCI EAFE Index Fund (AMEX:EFA) or the iSharesMSCI Emerging Markets Index (AMEX:EEM), among many others. If you want retail stocks, look at iSharesDow Jones U.S. Consumer Services Sector Index Fund (AMEX:IYC), Vanguard Consumer Discretionary VIPERs (AMEX:VCR), and Retail HOLDRs. For a software focus, consider the Software HOLDR (AMEX:SWH). For regional banks, check out the Regional Bank HOLDR (AMEX:RKH). You get the idea, right? There are scores of ETFs to suit all kinds of investing needs.
You can learn more in our ETF Center, such as how ETFs stack up against mutual funds, how to develop an investment strategy with ETFs, pitfalls to avoid, and how to avoid ETF imposters. These articles may also be of interest:
- Mutual Funds vs. ETFs
- Three Things to Know About Your ETF
- Buy the Whole Mall
- ETFs and Falling Fund Fees
This article was originally published on Dec. 15, 2005.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
