Exchange-Traded Funds

What are exchange-traded funds?

An exchange traded fund or ETF is part stock, part mutual fund. It trades like a stock, but everything else about it is like a mutual fund. In fact, most ETF's have a mutual fund that it mirrors. Most of those mirrored mutual funds are are index funds.

What are the differences between exchange traded fund and a mutual fund? (Other than how they are traded)

If you invest $1000 into an exchange traded fund and its mirrored mutual fund, the value of each will stay roughly the same. However, you will have to pay a broker to buy or sell an exchange traded fund. Conversely, with a mutual fund, usually you don't have to pay any fee to purchase shares -- unless there's a load fee. Since costs play a huge part in your overall returns, this is not a trivial fact. Offsetting the broker cost is the lower expense ratio for exchange-traded funds. Therefore, if you could buy ETF's for free, then ETF would be a cheaper investment than the mirrored mutual fund.

For example, Vanguard's Total Stock Market Fund includes nearly all US stocks on the market. You can get either the ETF VTI (new window) or the index fund VTSMX (new window). The VTI ETF has an expense ratio of 0.07% and the expense ratio of the index fund is 0.18%. If you look at the top 10 holdings of each one, the percentages are identical. Therefore, before costs, these two funds are going to give you the exact same return. If you can get free stock market trades, then buying the exchange traded fund seems like the way to go. If you cannot get free trades, then it is probably better to stick with the mutual fund.

One big bonus that might have you buying the ETF is that the minimum investment doesn't usually apply to an ETF. For example, the VTSMX fund requires a $3,000 minimum investment. For a beginner investor that can be a huge amount. However, buying the exchange-traded fund might still not be your best option if you're investing a small amount because the broker fee will be large relative to your investment. For example, if you're investing $200 and you have to pay $5 to a broker, then you're already down 2.5%! And eventually, you'll probably sell it and incur another broker fee.

ETF's could also prevent you from practicing dollar cost averaging - which is a very important part of investing successfully. In this case, I would recommend saving up in a money market account for the mutual fund version.

There are ways to eliminate or reduce the broker costs with etf investing. Click here to get more details.

return from exchange-traded funds to index funds

beginner investing made easy home