Most investors – especially those who only purchase stocks for their retirement accounts – usually shy away from buying individual stocks in favor of mutual funds. These funds are a basket of individual stocks or other assets that cumulatively return a profit. At least, that's the goal.
Mutual funds are often considered safer and less volatile than buying individual shares, with professional fund managers doing the stock picking. But those stock pickers charge fees, which can cut into your portfolio's earnings. And if they pick wrong, your portfolio suffers.
In recent years Exchange Traded Funds, or ETFs, have emerged as alternatives to mutual funds that might give your portfolio a boost. They work in much the same way as mutual funds but are usually less costly. It's important to understand the differences between the two.
While ETFs are similar to mutual funds, in that they are a collection of assets, they are similar to individual stocks in the way they trade. Holding assets such as stocks, bonds or commodities, an ETF's value fluctuates throughout the trading day, just like a stock.
For example, a few years ago when gold prices were rapidly rising, gold ETFs gave investors a way to quickly buy the precious metal without actually taking delivery of it. For example, SPDR Gold Shares, ticker symbol GLD, could be purchased at a share price, just like a stock. Each share was backed by gold bullion, owned by the fund. The ETF transaction price rose and fell with the price of gold, as well as investor demand for the ETF.
In addition to commodities like gold, there are ETFs for stocks and bonds. Stock ETFs are usually broken down in a way that the fund offers exposure to a particular class of asset. For example, if you want exposure only to blue chip companies like IBM or Microsoft you could buy a large cap ETF, which would be made up of stocks of those kinds of companies.
Other ETFs can give you exposure to small but growing companies or companies in emerging markets. In the latter case, an ETF might be the safest way to get emerging market exposure since it would be hard for an individual investor to educate themselves about these sometimes volatile markets.
Let's say you only want to invest in companies with solid fundamentals, such as strong cash positions and limited debt. There are ETFs that only include those kinds of companies.
Suppose you want to invest in companies that pay attractive dividends, but aren't sure which companies will continue dividends at their present level. Your answer might be an ETF made up of carefully-chosen dividend stocks.
While ETFs generally have lower fees than mutual funds, an investor should always be aware of the costs. When considering an ETF, check its expense ratios. That's the percentage of the assets taken out each year to cover fund expenses.
If your ETF has an expense ratio of 0.25%, you'll pay a fee of about $2.50 for every $1,000 invested. You'll also pay a commission when you buy or sell an ETF, just as you would with a stock. But you can buy and sell them using an online brokerage account, where trading fees are minimal.
There are other things to look out for. According to the experts at Morningstar, an investment research firm, you should avoid placing orders for an ETF near the open and close of trading. For example, at the start of trading ETF prices may adjust to the difference (premium or discount) between the previous day's closing price and their net asset value. This can result in ETF prices moving in the opposite direction of their underlying holdings. As the closing bell approaches, market makers often begin to take down positions and hedge their books.
Avoid volatile trading days
On days when the market is volatile, with extreme movement up or down, it's a good idea to avoid trading ETFs. Volatility can sometimes put some distance between a fund's underlying value and its price.
According to Morningstar, there are times when a mutual fund might be a better choice than an ETF because of brokerage fees. These costs are more important if you're frequently investing a small amount of money. In that case, an index mutual fund might be a better option if you can find a similar one.
As with any investment, do your research and consult with a trusted and objective financial advisor.