Exchange-traded funds (ETFs) are a type of investment fund which can be bought or traded like stocks. They have become increasingly popular as of late, but why?
To explain the advantages of ETFs, we’ll be building off general understanding about how investment funds and stocks function.
The basis about exchange-traded funds
Exchange-traded funds are, in some ways, like a hybrid of investment funds and stocks. They share characteristics of both.
Investment funds are like pizzas. An assortment of different ingredients is layered across the proverbial pizza fund like a meat lovers’ delight—cut up, and sold to individual investors as shares. The ingredients of an investment fund may include different securities like bonds, stocks, and cash alternatives. This diversifies their securities.
Investment funds are beneficial because they are diversified (think: not just pepperoni bonds, but also salami stocks and meatball money market instruments), varied (meat lover’s, veggie lover’s, and barbecue chicken mutual funds have different ingredients).
And, depending upon the type, funds can be managed by professional financial chefs. In other words, different types of investment funds incorporate different types of securities.
Some types of investment funds are also managed by professional brokers so that you don’t have to worry about selling or buying individual securities to keep your investment fund healthy.
Corporations sell “slices” of their company in the form of stocks/shares/equities in order to fundraise for themselves, thus distributing investment risks and benefits to stockholders. As the owner of a piece of a particular corporate pie, shareholders are entitled to a proportional share of earnings and losses.
So, like index investment funds, exchange-traded funds are passively managed, relatively cheap in comparison with other investment options, and diversified. And, like stocks, ETFs can be intraday traded and bought through brokerage accounts. Resultantly, there is a range of benefits for investing in ETFs derived from this attractive mixture of characteristics.
In other words, diversification through exchange-traded funds is the idea of not putting all of your eggs in one basket. If you have invested all of your money in one stock, you’re in a precarious position because all of your investment depends on if that company does well or not. If it does well, you could stand to make a lot of money.
However, if it does poorly, you might suddenly find yourself losing a pretty penny. Because ETFs represent a combination of shares of many different companies, corporations, and other securities, the risk is spread out.
While this benefit might not matter much to long-term investors, some folks like the flexible trading that ETFs offer. Mutual funds can only be traded once daily after the market has closed.
On the other hand, intraday trading is allowed for ETFs. This type of during-the-day trading can be risky but may turn a profit. This flexibility is another of the many benefits of investing in ETFs.
ETFs have lower administrative costs than mutual funds, often because there are fewer client-related services available and because larger brokerage firms manage ETFs. Additionally, as compared with mutual funds, exchange-traded funds have no redemption fees.
This type of fee exists to discourage short-term trading of other securities, which can allow short-term traders to make profits fast. By eliminating this type of fee, ETFs can be cheaper, especially for folks interested in this type of trading.
Other benefits of investing in ETFs are linked to tax advantages. Unlike mutual funds, ETFs are not subject to capital gains taxes (tax levied on the profit you make on the sale of an asset) in the same way as mutual funds. In the case of mutual funds, capital gains taxes are applied every single time associated assets are sold.
However, for exchange-traded funds, capital gains taxes are only applied if the whole investment is sold. In other words, as long as the ETF is yours, you do not have to pay this type of tax on it. This makes them more efficient and keeps you from losing more money to taxes.
As far as taxing on ETF dividends goes, taxation depends on the type of dividend your ETF issues. Stock-holding ETFs typically issue dividends on an annual basis while bond-holding ETFs tend to do so every month. Qualified dividends meet certain criteria like holding periods and are taxed at a lower rate (according to your tax bracket) than unqualified dividends.
Understanding the distinction between the types of dividends paid by different ETFs can help you select an ETF that meets your needs.
Don’t let the technical jargon scare you off. The numerous benefits of investing in exchange-traded funds have made them increasingly popular amongst new and seasoned investors alike. The low cost, flexibility, tax benefits, and potential to diversify your portfolio are just a few of the benefits of investing in ETFs.
While talk of mutual funds, ETFs, and portfolio diversification might feel as though it goes right over your head if you’re just getting started, consider what learning about these topics can do for you.
Gaining financial literacy about these investment basics is your first step to becoming a successful investor!