Transparency
Index-linked ETFs are completely transparent. With an index-linked
ETF, you know the exact holdings in the fund—it mirrors the
index. Conversely, a traditional mutual fund’s holdings are
only disclosed on shareholder reports semi-annually.
Consistency
When investing in ETFs, you always know exactly what you own. If you
purchase the S&P 500 ETF, you know you will always own the 500
largest companies in the United States. Or, if you buy the Dow Jones
Real Estate ETF, you know you will always own real estate stocks.
However, when investing in a traditional mutual fund, there is no
way of knowing exactly what you will get.
Liquidity
Since ETFs are traded on an exchange, positions can be bought and sold
very easily. Shares trade throughout the day between buyers and sellers
just like normal stocks. The trading of these fund shares on a stock
exchange gives the ETF its name—Exchange-Traded Fund. With
traditional mutual funds, shares are redeemed directly by the fund
company at the end of the trading day, creating an “unknown”
for investors wanting to sell back their shares. ETFs give you ultimate
flexibility and control when buying and selling shares.
Low Cost
ETFs are passively managed. That is, there is no one person making daily
decisions whether to buy or sell stocks. Rather, each ETF is managed to
mirror its index. That is, an ETF is only reconfigured when its constituent
index is rebalanced. This limited amount of trading significantly cuts down
on transaction costs. In addition, without a manager making daily decisions,
the expense ratios are much almost always lower than mutual funds.
Low Turnover & Low Tax
Turnover is how often stocks or bonds are bought and sold within an
account. Higher turnover means more trades are being made within your
portfolio, which in turn leads to higher taxes. ETFs, however, have low
relative turnover and therefore lower tax implications. For example, if a
share of stock owned by a traditional mutual fund is purchased at $10 and
sold at $20, then the gain is $10. That $10 gain is then taxed by the IRS as
income. So, if shares are bought and sold less often, gains will be taxed less
often. Lower turnover in ETFs equates to less taxes paid on investment gains.
Diversification
ETFs allow an investor to diversify their portfolio very easily. For example,
just by investing in four ETFs representing the Russell 3000 Index, MSCI EAFE
Index, MSCI Emerging Markets Index and the Lehman 7-10 Year Treasury Index, you
are effectively be diversified amongst both bonds and stocks representing over
4000 companies from around the globe.
Manager Risk (or lack thereof)
When buying into an actively managed mutual fund, there are many types of risk.
Besides the unavoidable risks involved in owning stocks and bonds, there is a
type of risk known as Manager Risk. This is a risk that the fund managers picking
positions to buy and sell could be wrong. They could make the wrong choice. They
could read the wrong data. They could misinterpret the data. They could be
influenced by many emotions. When investing in ETFs, there is no Manager Risk.
The positions owned are selected through a mathematical process. For example, the
S&P 500 is comprised of the 500 largest companies in the United States. There
is no emotion or decision-making involved. Utilizing ETFs for your investment
eliminates Manager Risk.
Performance
ETFs perform better. In general, traditional mutual fund managers do not beat the
index. From studies done in the last half century, on average, actively managed
portfolios underperformed their comparable index by 1-2%. Most of the poor
performance can be attributed to higher costs involved with active management,
such as transaction costs (many more trades are being made) and manager salaries.
Source: Active vs. Passive Management, www.indexfunds.com
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