What are ETFs?

ETFs are "exchange traded funds," a rapidly growing form of investment that everyone should understand -- ETFs typically hold expenses down, which means more money in your pocket.

Somebody's catching on: new ETFs are appearing at a rate of one a day, according to Kiplinger. You can now choose from among 750 ETFs, and their total assets are approaching $1 trillion. 

Think of ETFs as a different way to do what mutual funds do. In fact, they're a lot like mutual funds. Kiplinger explains:

Typically, an ETF holds a basket of securities that track the performance of a specific stock index, bond index or other benchmark. So ETFs are much like traditional index mutual funds. ETFs cover all the stock, bond, real estate and other investments that make up complete portfolios. 

ETFs exist for every imaginable investment category -- from something as narrow as a single commodity (such as timber) or a single industry (such as health care) to something as broad as the complete domestic blue-chip stock market.

Here a few characteristics of these funds.

Minimum purchase. Traditional mutual funds come with investment minimums -- often $2,500 or more -- but you can buy ETFs for much less. For example, a share of SPY, an ETF that tracks the S&P 500, costs about $110. Many others sell for much less. Of course, you have to pay a brokerage commission when you purchase an ETF, so it would be expensive to buy a small number of shares.

 

Costs. Because most ETFs follow indexes or simply own the major companies in a particular sector, they are cheap to operate. They don’t have a large staff of managers and analysts, as do many actively managed mutual funds. So the expense ratio of a typical ETF that invests in large growing companies, such as iShares Russell 1000 Growth Index, is a mere 0.20%. That means for every $1,000 you have invested in the fund, you pay just $2 in expenses annually. Actively managed stock mutual funds usually charge more than 0.75%, and often well over 1%. Even traditional index funds usually charge more than ETFs. 

 

Taxes. ETFs are tax-friendly. That’s because ETFs have lower portfolio turnover than regular mutual funds and distribute fewer capital gains. (Many ETFs don’t pass along gains at all because they never change investments.) Although that doesn’t matter if you hold an ETF inside an IRA or 401(k), it will boost your return in a taxable account. 

 

Kiplinger has a lot more on ETFs, including how to buy them, here.