I sometimes hear people talk about ETF investing as something special, different, maybe even sophisticated. Allow me to attempt to demystify.
ETF stands for Exchange Traded Fund. They are pooled investments that trade on an exchange, which means you can buy and sell them throughout the day. This is unlike traditional, open-end mutual funds, which are bought and redeemed daily and only directly from the mutual fund company itself.
There are more than 2,000 different ETFs available, and almost all follow an index. So, think of them as index funds trading throughout the day. The indexes they follow can be like the familiar S&P 500 or Dow Jones Industrials, or something more esoteric, like social media companies or pet-care companies.
Be careful, though, as some ETFs do not trade very often. If so, I think it may be better to stay away, as you may get a less favorable price during a sudden large selloff.
Next, keep commissions in mind. If you save to invest frequently, maybe per paycheck, buying ETFs with relatively small amounts potentially could make the commissions add up to a significant “toll.” Then, maybe consider open-end index mutual funds, which may not charge a load (“load” is mutual fund lingo for commission).
A potential benefit of ETFs is that they may be more tax efficient than mutual funds. If you own mutual funds, you might be used to receiving a form 1099 early in the year listing your capital gains, even if you never sold any mutual fund shares. This happens because mutual fund companies may sell investments in the fund and realize gains. The fund is required to distribute these capital gains to you, the shareholder.
Studies show that the potential avoidance of capital gains distributions may equal a full percentage point of your total return. That’s significant, as your long-term return may be less than 10% annually.
In the end, I believe most ETFs are pretty straightforward. Like any other investment, use them if you believe they fit with your overall portfolio plan.