Investing in Exchange Traded Funds
Exchange Traded Funds (ETFs) are a relatively new type of investment vehicle and have become very popular in recent years. Since 2000, investments in ETFs have grown from less than $50 billion to almost $2 trillion at the end of 2014. What started out an alternative to a few index mutual funds has grown into an investment category that includes over 1200 ETFs with investments in everything from stocks to bonds to commodities.
ETFs are investment funds that offer many benefits like mutual funds such as diversification and professional management. However, there are significant differences that are important to understand. Below are some of the similarities and differences.
Most ETFs just hold the components of an index and are not actively managed. An example would be an ETF that just holds the individual stocks of the S&P 500. Other ETFs focus on segments of the market such as small capitalization stocks or stocks within a specific industry. ETFs can also focus on individual precious metals like gold or silver and there are ETFs that own the components of various bond indexes.
In general, the portfolio managers of most mutual funds choose investments that they believe will perform better than the overall market. With ETFs, they often hold the components of an index with an objective of just matching the performance of the index.
Buying and Selling
Fees and Commissions
Buying or selling ETFs is like buying or selling individual stocks through a brokerage firm and commissions are charged. Some mutual funds are no-load and can be purchased directly from the mutual fund company without commissions. Mutual funds purchased through a stock brokerage firm typically have commissions charged on their purchase.
In general, ETFs will have lower asset management fees but with commissions charged when bought or sold. Mutual funds will usually have higher asset management fees, but may not have commissions if purchased on a no-load basis from the mutual fund company.
Levels of Risk
Income Tax Implications
The taxation of mutual
funds is somewhat different. While the dividends and interest are reported
on Form 1099, mutual funds are also required to distribute net realized
capital gains resulting in the reporting of that gain even though the
mutual fund shares had not been sold. This results in the necessity to
keep track of the resulting adjustment of the owner's cost basis. Most
mutual funds and brokerage firms handle this for investors.