Investments 101 – What is an ETF and What Can it Do For Me?

Investing for a financially secure future is more important than ever before, but the terms used by investment professionals can be confusing. The jargon used by many financial planners and brokers can be enough to make would be investors run the other way, but it is important to sort through the confusion and learn as much as possible about the world of investing.

That is because an informed investor is far less likely to be taken advantage of than one who simply allows others to make these important decisions for them. Investing can be confusing, but a little bit of research and hard work can help sort it all out.

What is an ETF?

One of the most important terms for new investors to learn about is the ETF. The term ETF stands for exchange traded fund, and there are many different funds on the market today. The simplest ETFs work similarly to index mutual funds, spreading out the risk of buying individual stocks and helping investors keep their expenses low.

Some of the most popular ETFs track the Standard & Poors 500 and the Nasdaq 100 market. The symbols for these ETFs are SPY and QQQQ respectively, and many investors and traders have used these funds to build a diversified portfolio going forward.

Couple getting Investing Advice about Stock ETFs

Couple getting Investing Advice about Stock ETFs

Investments like the SPY and QQQQ ETFs are similar to mutual funds that invest in the S&P 500 and Nasdaq markets, but there are some important differences as well. It is important for investors to understand both the advantages and the drawbacks of the ETF approach before getting started.

Advantages of ETF Investing

Investing in ETFs offers a number of unique advantages for investors, including:

 ETFs are priced and repriced many times throughout the day. While mutual funds investors must accept the end of day price when they buy or sell, investors in ETFs can purchase and sell their shares throughout the day in real time. This allows investors to buy and sell at specific prices, providing the potential for better profits and greater control.

ETFs that invest in a specific index can have extremely low expense ratios. The expense ratios on many well diversified ETFs are lower than even many low cost mutual funds. The expense ratios for some ETFs are as low as 0.18%, compared to more than 1% for many actively managed mutual funds and about 0.25% for low cost index mutual funds.

ETFs can be a very tax efficient way to invest. Like index mutual funds, ETFs offer excellent tax efficiency. Since there is almost no trading going on, there are fewer mutual funds, and fewer taxes to worry about. This makes ETFs an excellent choice for taxable accounts.

Disadvantages of ETF Investing

Of course no investment is perfect, and it is important for investors to understand the potential drawbacks of investing in ETFs. Some of the negatives associated with this investment approach include:

Buying an ETF generally means incurring a brokerage commission. Unlike investing in a no load mutual fund, which can be done directly through the mutual fund company, buyers of ETFs will typically need a broker to complete the transaction. The good news is that there are plenty of low cost brokers around, but it is important to factor in the cost of the commission in order to make a valid comparison between ETFs and index mutual funds.

ETFs may be more expensive than mutual funds, especially for smaller accounts. Because they must be purchased through a broker, the costs associated with ETF investing can take a big percentage of a small account. It is important to compare costs carefully when dealing with small amounts of investment funds.

It can be difficult and expensive to reinvest dividends and capital gains. While mutual funds are able to reinvest any dividends and capital gains automatically, owners of ETFs will generally have to reinvest their earnings as they accumulate. Depending on the brokerage company this type of reinvestment could mean another brokerage commission and additional costs.
As with any other type of investment, it is important to carefully compare the costs and benefits of ETF investing with other investment options. ETFs can be a great investment, but these unique trusts are not for everyone. Only by comparing the costs of each approach can the smart investor determine the right path.

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