Are you afraid of ‘spiders’? No, I’m not talking about those hairy, eight-legged creatures. I’m talking about Exchange-Traded Funds (ETFs). It is important you understand this investment vehicle because they offer several advantages over mutual funds. Read on to find out how ‘spiders’ and other Exchange-Traded Funds can be a valuable part of your portfolio.
Any time you invest in the stock market you want to make sure you minimize your risk through diversification. That can be difficult to do using individual stocks. That’s why so many people and advisors turn to mutual funds. A mutual fund allows an investor to easily diversify because every dollar you invest is divided among many underlying investments. For instance, a mutual fund that is designed to mimic the S&P 500 Index would own the same 500 stocks that make up the index in the same proportion as the index.
Exchange-Traded Funds provide the diversification benefits of a mutual fund with the advantage of being traded like an individual stock. Whereas a mutual fund can only be bought or sold based on that day’s closing price, Exchange-Traded Funds can be bought or sold anytime throughout the trading day. This gives you greater flexibility.
Exchange-Traded Funds are designed to mirror a market index. There is an ETF for practically every index available. The three most popular stock market indices are the Dow Jones Industrial Average, the S&P 500 and the NASDAQ. The ETFs that mirror these indices are referred to as Diamonds, Spiders and Cubes because their symbols are DIA, SPY and QQQ.
Exchange-Traded Funds can be used in all areas of a portfolio. Many are available that invest in the stock of large, medium or small companies both in the U. S and internationally. And Exchange-Traded Funds aren’t just for stock-based investments. There are separate ETFs that invest in bonds, real estate, precious metals and other commodities. There are ETFs designed for growth and others designed for income.
Exchange-Traded Funds are not actively managed like some mutual funds. For instance, actively-managed mutual funds try to out-perform a market index by only owning some of the investments that make up that index. Many also have the ability to increase the amount the have in cash during declining markets. When using Exchange-Traded Funds, these decisions are up to the individual investor and/or their advisor.
This decision making flexibility means that Exchange-Traded Funds offer tax advantages not available in a mutual fund. As people take their money out of a mutual fund, it can force the manager to sell investments that would otherwise be held. Each time a mutual fund manager sells an underlying investment, it generates a capital gain or loss for the mutual fund investor.
So even though the investor may own the fund for several years, they must pay taxes based on the decisions of the mutual fund manager each year. Particularly frustrating to mutual fund investor’s is having to pay taxes on a fund in a year that it has declined in value! If the same investor owned an ETF, he/she would be able to control the timing of the sale and the resulting taxes in order to minimize their effect.
The internal expenses of most Exchange-Traded Funds are very low. The average actively-managed mutual fund may have internal expenses over 1% per year. The internal expenses of Diamonds, Spiders and Cubes are less than 1/5 of 1% per year. (Since ETFs are purchased like a stock, there is a commission to buy and sell them. The use of a discount broker should minimize this expense. )
For many of my clients, about 50% of their portfolios are made up of Exchange-Traded Funds because they give us the ability to quickly respond to unpleasant market events. If you are concerned about the impact a terrorist event can have on the value of your portfolio then you may want to consider ETFs for a portion of your money.
So don’t be afraid of ‘Spiders’ and consider adding Exchange-Traded Funds to your portfolio. They can lower your costs, increase your flexibility and give you greater control over taxable events while still participating in the potential growth of the market.
Nationally-syndicated financial columnist and Certified Financial Planner® Jeffrey Voudrie provides personal, in-depth money management services and advice to select private clients throughout the USA. He’ll answer your financial question – FREE at http://www.guardingyourwealth.com