If your friend says ETFs are safer than stocks and mutual funds, he is probably right. In this article, you will see what is an ETF and why it is considered safe. You will know why ETFs have lesser brokerage fee and are tax efficient.
But before going further, do you want to know whether large number of investors trust ETFs. Here is your answer.
How Popular Is ETF Among Investors?
ETFs were launched just decades ago. Today, ETFs funds have grown in value across the globe. In US alone, these funds have crossed 2 trillion dollar mark.
Without the trust of millions of people, the ETF industry couldn’t have grown this big. Hence, there is no reason for you to ignore this safe investment option.
So, What Is An ETF?
You probably would have heard a lot about mutual funds.
ETF (or Exchange Traded Fund) draws its inspiration from mutual funds. But there are noticeable differences, which make these funds unique.
Before seeing how an ETF is different from mutual funds, you have to learn their similarities. This will help you clearly understand something called pooled investment. (Both ETFs and mutual funds come under pooled investment category. Below you will see what is a pooled investment.)
How ETF Is Similar To Mutual Fund? Why Both Are Called Pooled Investment Vehicles?
- Both Are Less Risky As They Are Pooled Investment Funds.
- Both Are Strictly Regulated. Your Money Will Be Safe
ETFs and mutual funds are created by fund management companies by investing in large number of assets (like stocks, commodities, etc). These funds are called pooled investment vehicles because, funds from thousands of investors are aggregated and then invested in diverse assets. In pooled investments, your risk of losing money during bad market conditions is less. This is because, even if one or more assets perform badly, the other better performing ones will save you.
If majority of the assets perform well, you can expect a steady improvement in overall asset value of the fund. This value is called NAV (Net Asset Value). Did you see the word steady before improvement? This word is placed for a reason, which is as follows:
Assume you have invested in a single stock, say of XYZ company. Now, if the company performs incredibly well, your investment will grow several folds in short period of time.
But this is not the case with ETF (and mutual fund).
This is because, an ETF manager would have invested your fund in hundreds of other companies including XYZ. There will be both good and bad performing companies. Hence, though the performance of XYZ will have a positive effect on overall ETF, you will not earn as much as a dedicated investor in XYZ.
Both ETF and mutual funds are strictly regulated. This means government keeps a close watch on how investors’ money is being spent.
How ETF is different from mutual fund?
- ETF shares can be bought and sold anytime in trading day
- In ETF You Will Know Where Exactly Your Money Is Being Invested.
- ETFs are less expensive to maintain than mutual funds
Mutual funds can be bought only at the close of each trading day. (Even if you place order through online broker in the morning, you will be allocated shares only in the evening). The price of each share of the mutual fund will be based on its net asset value (NAV).
But ETF shares can be bought and sold just like any other stock. The share price will be constantly updates just like stocks.
In case of mutual funds, your fund manager is the only person who decides when and where to invest your money. He will work tirelessly with an objective to generate profits to you. But he may not disclose where your money is invested. By law he is not obliged to do so.
In case of ETF, you will know exactly where your money is being invested. This is where government regulation helps you. On a daily basis ETF managers need to disclose the holdings.
ETFs usually track an index like S&P 500. But what does this mean? The ETF manager will invest your money in such a way that it behaves similar to the index. If index goes up, your performance improves and vice versa.
Most of the tasks of ETF fund managers can be automated. This type of management can be called passive management.
In case of mutual funds, you will find high paid professional teams working round the clock. There will be automation but not to an extent as in ETF. This is called active management.
In simple words, mutual fund managers need to work more than ETF managers. You and other investors have to share their fees. Fees for an ETF will be much lower than a mutual fund. Hence you will pay less fees for ETF.
Taxes with ETF are much lower compared to mutual funds. There are plenty of reasons which are beyond the scope of this article. But the important point, is that you have to pay less and can remain happy!
Hope this article helped you to learn basics of an ETF.