How to Choose an Exchange-Traded Fund (ETF)

Exchange-traded funds, commonly called ETFs, are index funds (mutual funds that track various stock market indexes) that trade like stocks. As such, they have all of the benefits of plain old index funds with some added punch. The fees for ETFs are often — but not always — cheaper than index funds, and they may cost you less in taxes.

Exchange-traded funds began trading more than 15 years ago, but in recent years they’ve been gaining in popularity against more mature mutual funds.

An ETF’s underlying net asset value is calculated by taking the current value of the fund’s net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. The net asset value, or NAV, is published every 15 seconds throughout the trading day. But the ETF’s NAV isn’t necessarily its market price. More on that in a bit.

When you purchase shares of a traditional mutual fund, the net asset value serves much like a stock price — it’s the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day.

ETFs, as noted, work a bit differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand. That’s why an ETF’s market price can differ from its net asset value. The way ETF shares are structured helps keep the gap between those two figures pretty tight.

Many investors – including the pros – have taken notice of these funds. Money invested in ETFs has more than quintupled over the past five years. The number of existing ETFs has skyrocketed at the same pace – investors now have hundreds to choose from. That number is still pretty small compared to the thousands of mutual funds that exist, but it is a lot of growth. And there are hundreds more on the way.

Investors like ETFs for several reasons:

Costs: Many good ETFs have very low fees, compared with traditional mutual funds.Taxes: ETFs are big winners at tax time. As with any index fund, the manager of the ETF doesn’t need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured (trust us, you don’t want to know how this works), they’re often more tax-efficient than traditional index mutual funds.

Diversification: Like index funds, ETFs provide an efficient way to invest in a specific part of the stock or bond market (say, small-cap stocks, energy or emerging markets), or the whole shebang (like the Standard & Poor’s 500).

Open Book: Again, since they track an index, you usually know exactly what’s inside an ETF. With traditional mutual funds, holdings are usually revealed with a long delay and only periodically throughout the year (mutual funds that track a specific index are the exception here).

User-Friendliness: ETFs can be bought or sold at any time during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day. If you’re investing for the long-term, this doesn’t really matter. It is nice to know, however, that you can usually get out of an ETF at any time during the trading day.

There is a small catch. Since ETFs trade like stocks, buyers must pay a brokerage commission every time they buy or sell shares. (Online brokerage commissions range from a few dollars per trade to $20 per trade, depending on the broker.) Those commission add up quickly, especially if you’re buying more shares each month. ETFs are great for lump-sum investors, but you should use a traditional index fund if you’re buying a little bit at a time.

Should You Buy an ETF?

There are a few situations where ETFS come in handy:

  • If you have a chunk of money you’d like to invest – say if you’re rolling money over from an old 401(k) to an IRA — ETFs could be a smart choice.

But if you want to regularly build on that investment a bit each month, stick with mutual funds that allow you to buy in without paying brokerage fees. Paying a commission will eat into your returns. And there are at least a handful of good mutual funds to choose from that track the big, popular stock indexes.

  • If you don’t have the $2,000 minimum investment required by some mutual funds, you can use ETFs as an alternative. You can assemble a decent portfolio with as few as three ETFs.
  • ETFs can perform the same acrobatics that stocks can. You can buy option contracts on many ETFs, and they can be shorted or bought on margin. Note: We don’t recommend that you try this as a long-term investor – leave these moves to the professionals.

How to Get a Good Deal on an ETF

You can buy ETFs almost anywhere you can buy a stock – they can be purchased through a broker or a brokerage account. Your best bet is through an online brokerage (like E*Trade, Charles Schwab or Fidelity) that charges low commissions.

Before you commit to a brokerage firm, however, make sure they offer everything you’re looking for. Some smaller outfits may only offer an edited selection of ETFs – though they should offer the most widely-used and easy to trade funds.

You’ll want a high-quality ETF that fits into your investment plan, so you must evaluate ETFs the same way you would any other mutual fund.

When considering an ETF, ask the following questions: What does the index track, how is it constructed, what’s inside and how long has it been around?

While ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, many ETF creators are stretching the definition of indexing. Meanwhile, some have cooked up new indexes that track arcane segments of the market. As a long-term investor, you want to avoid newfangled ETFs that track esoteric benchmarks.

Consider your costs before investing. An expense ratio tells you how much an ETF costs. The amount is skimmed from your account and goes towards paying a fund’s total annual expenses. Remember, the expense ratio doesn’t include the brokerage commissions you pay to buy and sell ETF shares.

The average ETF carries an expense ratio of 0.44%, which means the fund will cost you $4.40 in annual fees for every $1,000 you invest. The average traditional index fund costs 0.74%, according to Morningstar Investment Research. On the flip side, there’s been a proliferation of more narrowly-focused and exotic ETFs – many of which are not only unproven, but more expensive. Avoid these funds unless you really know what you’re doing.

If you’re thinking about investing in a life-cycle fund that invests in ETFs check to see if it will charge an extra management fee. Life-cycle funds, also known as target-dated retirement funds, invest in a combination of stocks and bonds funds whose mix becomes gradually more conservative as the investor reaches retirement. You might be better off in a target-date fund that invests in regular index funds and doesn’t charge this extra fee. Be sure to do a side-by-side comparison.

Consider the tax consequences of your investment. Most ETFs are pretty tax-efficient because of the special way they are built. However, some ETFs are mimicking newer, less-static indexes that trade more often. These funds may trigger more capital gains costs.

Meanwhile, some ETFs that invest directly in precious metals, such as gold, are considered “collectibles” and are taxed at a much higher rate. Gains on collectibles are taxed at a maximum rate of 28%, rather than the 15% long-term capital gains rate.

Don’t forget that trading in and out of ETF shares can generate taxable gains, just like stocks.

Last, know the key players and their nicknames. Different ETF providers call their ETF wares different things:

Other ETFs are so popular they’ve earned nicknames of their own:

  • Spiders: Not to be confused with State Street’s ETF brand, this is the original spider – the first ETF ever – was launched by the same firm in 1993. Officially known as the SPDR S&P 500 ETF (SPY), it tracks the S&P 500 Index.
  • Cubes or Q’s: This refers to the widely-traded PowerShares QQQ Trust, which tracks the Nasdaq 100 Index, or the largest 100 non-financial stocks in the Nasdaq Composite Index. The NASDAQ is largely comprised of tech stocks.
  • Diamonds: More formally known as the Diamonds Trust Series I (DIA), this ETF tracks the Dow Jones Industrial Average.
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