Who feels tired of having to pick from hundreds of mutual funds? What investment product is right for you? Trying to evaluate what investment product is best for your savings can feel like an overwhelming task.
We know how important proper diversification in your portfolio is. One way for good diversification is via an index strategy. But as you know, you can't 'buy' an index directly. You'll have to do it through an auxiliary channel, like an Index Fund, Mutual Fund, or ETF. But which one is right for you?
The real problem in getting your portfolio properly diversified is minimizing two factors that put a huge drag on how fast your nest egg grows over time: costs and taxes.
An ETF, or Exchange-Traded Fund, minimizes costs and capital gains taxes because it acts like an index but is structured like a stock.
Just like a Mutual Fund or an Index Fund, an ETF is not an index, but it acts like one. Think of an ETF as a mirror; it reflects an index by mimicking it. For instance, the Dow (Industrial Average) is a price-weighted index of 30 large U.S.-based companies. The equivalent ETF (called "Diamond" ETF) looks and acts the same as the Dow.
Unlike a Mutual Fund or an Index Fund, an ETF is structured and trades on the market in much the same way a share of stock in IBM is structured and trades on the market. These attributes add some oft-overlooked advantages to ETFs that separate them from Mutual Funds and Index Funds.
- Because ETFs trade on the market as a stock, you can carry out the same types of trades that you can with a stock. For instance, you can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as you wish (there is no minimum investment requirement). For you more savvy investors, many ETFs have the capability for options (puts and calls) to be written against them.
- Because ETFs are simple to manage, they have a lower expense ratio than comparable mutual funds, which are expensive to run. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.
- ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders so that you generally only realize capital gains when you sell your own shares or when the ETF trades to reflect changes in the underlying index. In most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset classes or categories.
Take a look at ETFs. You won't be disappointed.