Exchange Traded Funds (ETFs) are alternatives to Mutual Funds, where Management Expense Ratios (MERs) are usually a fraction of the price. MERs are the costs to keep the funds active. These costs include but are not limited to, operational costs, and trading costs. The MERs are typically passed on to the Mutual Fund/ETF holder. For example, a MER of 1% translates into a cost of $10 for every $1000 invested. Many investors are switching over to ETFs from Mutual Funds, since they are more flexible, and have lower MERs. The ETF Market is rapidly growing – currently it is an approximately $3 Trillion Market (Market Realist). According to BlackRock, $347 Billion of new money was poured into the Global ETF Market during 2015, setting a new record.
History of ETFs
ETFs were launched in 1993 by State Street Global Advisors, where it was marketed towards institutional investors (The Wall Street Journal). During the early days, ETFs were used by Portfolio Managers for sophisticated investing strategies, such as hedging, and keeping cash active. Nowadays, many individual investors trade ETFs – thanks to the help of the internet. The rise of online personal finance research has helped ETFs become increasingly popular. Many investors (and millennials) appreciate ETFs for two major reasons – cheaper MERs, and flexibility to buy/sell throughout the trading day.
How Do ETFs Work?
Similar to Mutual Funds – ETFs consist of a pool of money that are professionally managed by Portfolio Managers. ETFs are typically classified by their risk type, typically conservative, balanced, and equity growth. Riskier ETFs hold more stocks than bonds, and vice versa for less risky ETFs. There are several types of ETFs, such as those who follow a specific index, or stocks with a specific market capitalization. Morningstar provides great reviews and insights on individual ETFs (reviews also include past performance, and compare the funds with their respective index). ETFs can be traded at any time during the trading day, giving it the advantage over mutual funds. Typically, mutual funds can only be traded at the end of the trading the day, giving it less flexibility to investors.
ETFs vs. Mutual Funds
An average individual investor may just park their money in mutual funds, since it’s professionally managed and typically offers lower risk through diversification. It’s important to take ETFs into consideration – ETFs and Mutual Funds are practically the same in terms of features and benefits. However, there are two major differences – fees, and liquidity.
In terms of fees – the average ETF expense ratios are usually under 1%. It can range between 0.20% – 0.80% (it depends on the fund, and the company). This is a bargain compared to Mutual Funds, which have expense ratios that are usually north of 2% – 3%. Over a period of time, the savings between ETFs and Mutual Funds would accumulate, assuming that the money is reinvested into the stock market. However, it’s important to do research on both, ETFs, and Mutual Funds. Although ETFs are significantly cheaper, there are still some Mutual Funds that outperform ETFs, even after expense fees.
Many Personal Finance Authors, such as Ramit Sethi and David Chilton praise ETFs. ETFs are extremely beneficial for investors at any age, especially for millennials. Because of the significantly lower fees, this investment tool can help millennials reach their savings goals within the short, medium, and long term. All in all, ETFs are known to be the more attractive substitute for Mutual Funds, as they offer the same features, with higher liquidity and more reasonable expense ratios.
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Writer: Jelani Smith
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