Advanced Personal Finance

The basics of ETFs is something I’ve wanted to investigate for a while now and I finally got around to it. I’ve read a couple of posts on other PF sites about ETFs (here’s an excellent one on how to construct a comprehensive portfolio using only three ETFs) and wanted to learn what they were all about. Here’s what I found out.

ETF Basics

An Exchange Traded Fund is a financial instrument that tracks an index, but trades like a stock. The index can be anything from the common (like the S&P 500 SPDR - also called a ’spider’) to the obscure (the Global Vaccine Index, whatever that is). There are currently over 200 ETFs being offered, many really narrow in scope. Keep that in mind when investing. It kind of defeats the purpose of investing in an index if the ‘index’ tracks only nanotechnology companies.

ETFs have a couple of nice advantages over index mutual funds:

• ETFs trade throughout the day, unlike a mutual fund which has its price set at the market close.

• ETFs have lower expenses than even index funds. The Vanguard Total Bond Market ETF, for example, has the stupid-low management fee of 0.09%.

• ETFs can be sold short and bought on margin.

• ETFs don’t have investment minimums. If you have $50, you can buy $50 worth of an ETF. Mutual funds have minimum investments usually starting at $1,000.

• ETFs only generate capital gains when you sell them, unlike a mutual fund.

Index funds for long-term investment growth

So if ETFs are so great, why would anyone invest in an index mutual fund? Well, mutual funds have one very important advantage.

Every index mutual fund I know of has a way to invest periodically, automatically. The programs go by names like “automatic asset builder” or “wealth builder.” They’re just automatic withdrawals from your bank account into your index fund. Typically, you can invest really small amounts every month (like $50 or $100) and avoid the usual minimum investment.

ETFs, because they trade like a stock, can only be purchased through a broker. Brokers charge a commission for every transaction (in and out), so fees can add up if you do small, regular investments.

If you invest small amounts regularly, an index fund is the way to go. If you have a large lump sum to invest, it makes more sense to use an ETF.

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This entry was posted on Tuesday, July 31st, 2007 at 8:08 am and is filed under Investments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.