The traditional portfolio has long been anchored by mutual funds, but a growing number of investors are embracing a nimbler, cheaper alternative. Exchange-traded funds (ETFs), which debuted in the early 1990s, have attracted a substantial amount of assets in recent years, recently surpassing the $1 trillion mark.
Unlike mutual funds, ETFs trade on exchanges like stocks. ETF shares can be bought and sold throughout the day, whereas mutual funds execute orders only once at the end of the day. The advantages of ETFs don't stop there.
Because most ETFs are passively managed—meaning they track an index and don't require a stock picker—they are cheaper to own than mutual funds. On average, actively managed mutual funds charge 1.30 percent in annual fees, according to fund tracker Morningstar, and index funds charge an average of 0.84 percent in annual fees. By comparison, the average annual fees of ETFs are 0.58 percent.
Investing in ETFs can also lead to lower tax bills. While mutual fund investors can incur taxes when a manager buys or sells securities, ETFs rarely generate capital gains distributions because of their unique structure. An added bonus is that ETF investors can delay paying taxes until they sell.
Transparency is another attractive feature of ETFs. On any given day, investors can see which securities the fund holds. With many mutual funds, holdings are only released on a monthly or even quarterly basis.
ETFs also offer exposure to a wide range of asset classes that, until recently, were nearly impossible for retail investors to access. "There's some interesting twists on investing that ETFs offer that mutual funds simply can't," says Jeff Tjornehoj, senior analyst at research firm Lipper. For example, investors can buy shares of SPDR Gold Shares ETF (symbol GLD), which tracks the spot price of gold and is physically backed by gold bullion. Less traditional asset classes like gold are becoming increasingly popular among investors, but most of the money in ETFs resides in broadly diversified indexes like the S&P 500. At about $80 billion in assets, the SPDR S&P 500 ETF (SPY) is the largest ETF offering, followed by SPDR Gold Shares.
An increasing number of stock investors are choosing ETFs over actively managed mutual funds to get targeted exposure to a specific slice of the stock market, such as large-cap U.S. stocks or emerging markets stocks. "[Investors] are using passive instruments to make their own bets," says Paul Justice, director of ETF research for Morningstar. "They're taking active management into their own hands." From the beginning of 2010 through the end of July, investors have poured about $91 billion into stock ETFs, and pulled more than $1 billion out stock mutual funds, according to Lipper.
Despite their many advantages, ETFs have some downsides. Although many mutual funds have minimum investment requirements, investors generally don't pay a fee to buy or sell them. Many brokerages charge commissions to buy or sell ETFs—sometimes $5 or $10 per trade. That may sound small, but over time these commissions can eat away at your return, especially if you're investing at regular intervals. However, a handful of firms, such as Charles Schwab, Vanguard, and TDAmeritrade, now offer a select number of ETFs that trade commission-free.
There are a growing number of highly specialized ETFs that may not be appropriate for typical retail investors, such as those that focus on individual countries or leveraged funds. "ETFs can be so narrowly defined that they can be very volatile and subject to swift downturns," Justice says, so it's important to do your research before investing.