What Are Exchange-Traded Funds (ETFs)?

What Are Exchange-Traded Funds (ETFs)? They are essentially a hybrid between individual stocks and mutual funds with characteristics of both. After some research on Yahoo! Finance and About.com, here are some highlights of Exchange-Traded Funds:

ETFs are similar mutual funds

ETFs are portfolios of many stocks, but their prices do not necessary match the net asset value (NAV) of the underlying stocks. It could be traded at a premium above the NAV, or at a discount below the NAV.
ETFs are usually set up in categories similar to mutual fund — i.e., small-growth, mid-blend, large-index, specialty-real estate, international, etc.
ETFs have expense ratio, but usually much lower than mutual funds of the same asset class.

ETFs are similar individual stocks

ETFs can be traded throughout the day.
Traders can short or buy ETFs on margin.
Brokers charges trade commission to buy and sell ETFs.
ETFs suffer from bid-ask spread, meaning you have to buy at a higher ask price and sell at the lower bid price; effectively, losing the 1/8 spread.

Moreover, ETFs are more tax-efficient than mutual funds. You can see the chart below — the big drop in HFCGX value is the huge distribution at the end of 2006. Luckily, this fund was in my IRA, so no tax!

VB versus HFCGX

Why I Like Exchange-Traded Funds (ETFs)?

In the post How Expense Ratio Affect Long-Term Performance?, I showed you how investing in mutual funds with high expense ratio can cost you 50% of your potential gain. With this in mind, I went back to review my IRA portfolio and found a fund that charges 1.23% (above my 1.0% maximum tolerance). This does not seem expensive, but it can cost me 30% of money invested if I keep it in the fund for 30 years. Also, as I mentioned earlier, ETFs tend to be more tax efficient than equivalent mutual funds making them more appealing in a taxable account.

Right now, I have enough money invested such that it is more expensive to invest in mutual funds than ETFs. So today, I went ahead and sold HFCGX and traded it for VB.

3 Comments

Lazy Man and Money
July 31, 2007, 9:39

I love VB and own that instead of a mutual fund. I also have VTI and Vanguard’s Health care ETF, VHT. I love ETFs.
Pinyo
July 31, 2007, 10:34

Lazy – hi again! I am just getting into ETFs. I sold some of my high expense mutual funds and now own some shares of VB, VBR, and VGT. I just love Vangard super low expense ratio, and great high yield / low PE combination.
Online Dividends
June 27, 2008, 18:29

That’s a great post Pinyo. I am thinking of “owning the world” through 2 etf’s – VTI and VEU. I haven’t gone as far as %-age exposure to bonds yet