Everyone wants to invest their money and one of the best places to do so is the stock market. After all, that’s why it was invented. But what’s the best/safest/easiest way to do it? Do you buy individual stocks? What about an index? Should you consider mutual funds? It can get confusing, which is why utilizing ETFs may be the best investing strategy for your goals.
What Is an ETF?
An exchange traded fund (ETF) is an investment that contains a basket of securities that can include stocks, bonds, commodities, or other assets. An ETF is essentially a mini-investment portfolio. Initially, ETFs were designed to track a specific index, such as the S&P 500, in which the fund would contain all of the holdings within the S&P. These index-based ETFs mirror the underlying index that they track.
ETFs have evolved over the years and can contain a myriad of investments, including bonds, foreign securities, and stocks within a specific sector or industry, such as the technology sector. For example, a gold ETF might track the price of gold. A bond ETF might hold certain types of bonds, such as U.S. Treasury securities.
ETFs are helpful since they're easier to invest in than buying all of the individual stocks or securities within the fund. For example, investors can purchase shares of a bank sector ETF instead of buying equity shares of every bank.
If you are looking for broad exposure to the stock market without a high level of risk, costs, or complications, a market ETF may be your best bet. It’s a simple investment product with minimal transaction costs and can provide a tax advantage for some investors and many other benefits.
If you think an individual company has potential, then buying that company’s stock would be a good idea. However, if you wanted to invest in the stock market as a whole, you’d have to buy many stocks across many sectors. That can be a problem for many reasons.
- Which stocks should you buy?
- How many shares do you need of each stock?
- How much will it cost in commissions and fees?
- Is it risky to buy random stocks?
However, with a market ETF, the number of stocks and shares is prepackaged in one asset. There is only one transaction at one price. You don’t have to go chasing after stock prices, which can get difficult. With one call to your broker, you can have instant exposure to the stock market.
As an ETF, an index is a collection of stocks as well. A market index is also constructed to represent the general price movement of the market it follows. However, it is not prepackaged like an ETF. You still have to buy individual stocks in what’s called a basket. You tell your broker to buy a basket, and he buys the individual stocks needed to fill the index basket. Again, that involves multiple transactions and fees, chasing stock prices, and sometimes some pretty complicated math.
The reason ETFs were created was to make it easier to buy baskets. Exchange-traded funds are made of the same stocks of the index they track, however, the assets in the fund are ready and waiting for your purchase. Instead of buying the index basket, you can buy one asset that acts as the index.
Mutual funds are closer to ETFs than any other asset. They are also mini-portfolios created to follow an index or other investments. However, their goal is to not just act like the underlying index, but instead, they try to beat it. While that’s not without its advantages, it can lead to higher transaction costs and risk. Stocks are traded in a mutual fund on a daily basis, sometimes without you even knowing. Fund managers sell and buy shares in your mutual fund all day long with the goal of trying to beat the market. Sometimes it works. Sometimes it doesn’t. However, all of those daily trades can rack up your commission bill.
Taxes play a huge role with mutual funds as well. If your manager sells a stock higher than he bought it, that is a capital gain. Uncle Sam wants his share of that gain right away. And sometimes, you don’t even know about it right away. One of the disadvantages of mutual funds is that they are not very transparent. You never know what’s in your fund, what trades are being made, or what are incurring capital gain taxes until you get a report.
With an ETF, you don’t pay capital gain taxes until you sell the entire asset; you always know what’s in your fund, and there’s no daily management. (with the exception of actively managed ETFs).