Have you wanted to get started on the stock market but are unsure how to invest your money? This article will help add clarity to one popular investment option, exchange traded funds (ETFs), you may want to consider.
An ETF is a fund that tracks indexes like the NASDAQ-100 Index, S & P 500 Index, Dow Jones etc. When you buy an ETF you are buying shares of a portfolio that tracks the yield and return of its index. The primary goal of an ETF is to replicate the performance of its index and not beat the index.
You may be wondering why you should invest in ETFs if their goal is not to beat the market? Although performance is important when selecting an investment option, it is not the only consideration. ETFs provide some very appealing qualities that are not present in other investment vehicles especially for those people who are getting started on the stock market.
ETFs use passive management which means the fund manager makes only minor, periodic adjustments to keep the fund in-line with its index. ETFs typically cover a discrete number of stocks which allows ETFs to mitigate any “managerial risk.” Managerial risk can make choosing the right fund difficult because you are often investing in a fund manager instead of the specific investments. This is not a concern with ETFs since passive management does not allow the manager the freedom an actively managed fund would have; therefore when you buy ETFs you are really buying the market.
Cost Efficient and Tax Efficient
ETFs are more cost effective and tax efficient than actively managed funds. Because an ETF tracks an index without trying to outperform it, the fund incurs fewer administrative costs than actively managed funds. Most ETF administrative costs are less than 0.2% as opposed to over 1% like mutual funds. Since ETFs offer lower fees there are fewer costs to diminish returns.
As previously mentioned, ETFs are passively managed which improves ETFs' tax efficiency. ETFs are traded less frequently than actively managed funds which results in less capital gain distributions. With less trading and less taxable dividends, ETFs possess a more efficient overall return on investment.
Another benefit that ETFs provide is flexibility. ETFs trade like stocks which means they are priced and traded continuously through the trading day. ETFs also typically trade at much higher volumes than stocks. The fact that ETFs are traded throughout the day and in high volumes means greater liquidity which enables investors to get into and out of investment positions easily.
Long Term Growth
Since the late 1970s there has been a trend that market indexes consistently established outperformed actively managed funds. This long-term out-performance presents a spelling reason to incorporate ETFs when implementing a buy and hold investment strategy. Now that you understand what ETFs are and some of the benefits they provide, you may still be wondering if they are right for you. You can ask yourself several questions to help determine if ETFs are suitable for you to get started on the stock market.
1.) Do you desire a return in-line with the market?
2.) Do you feel more comfortable with lower volatility investment options?
3.) Do you want lower fees and greater tax efficiency?
4.) Do you appreciate having the ability to get into and out of your investments easily?
5.) Do you typically buy investments and hold them for long periods of time?
If you answered “yes” to most, if not all, of the above questions then you may want to consider ETFs. If you would like to learn more about ETFs and see lists of specific ETFs you can invest in, check out a couple of my favorite resources, Vanguard's website and iShares website.
You will discover that there are ETFs for a variety of categories including domestic stocks, bonds, sectors and international. Given the diversity in ETF options, you may decide to construct a portfolio that incorporates multiple ETFs. Regardless of the ETFs you decide to invest in, always remember to consult the ETF's prospectus and reports to understand the risks involved and to learn additional details about the specific ETF.