What are Exchange-Traded Funds (ETFs)?

What are Exchange-Traded Funds (ETFs)? They are a relatively new class of investment funds that hold underlying assets like a mutual fund, but are traded on a stock exchange like individual stocks. To better understand ETFs, here are some of the characteristics groupped into their similarity with mutual funds and individual stocks.

ETFs are similar mutual funds

  • ETFs are investment portfolios consist of many underlying 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 set up in categories similar to mutual fund — e.g., small-growth, mid-blend, large-index, specialty-real estate, international, etc.
  • Investors has to pay annual expense ratio to invest in ETFs, but these expenses are usually much lower than mutual funds of the same asset class.

ETFs are similar individual stocks

  • ETFs can be traded throughout the day.
  • Investors can short or buy ETFs on margin.
  • Stock brokers charge 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.

Why Exchange-Traded Funds (ETFs) are Great Investments

In the post How Expense Ratio Impacts Your Investment Performance, I showed you how investing in mutual funds with high expense ratios can cost you as much as 50% of your potential gain over the long haul. 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 a lot of money if I keep 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.

5 thoughts on “What are Exchange-Traded Funds (ETFs)?”

  1. 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.

  2. 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 🙁

  3. Pinyo: Do ETF’s actually own shares of the individual stocks listed in their “holdings list” or do ETF’s “create” a mimic of the share at a given price the stock represents? An example would be a holding of ishares IVV where they have 3.51% in Exxon Mobil Corp? Does IVV actually own the Exxon Mobil Shares?

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