Simply put, Exchange Traded Funds (ETFs) are like mutual funds that trade like individual securities. They offer the advantages of traditional mutual funds with the trading flexibility of individual stocks and bonds. Most ETFs are index portfolios, meaning they seek to closely track the performance of specific market indexes. Investors can choose from a wide variety of ETFs that reflect virtually every segment of the domestic and international equity and fixed income markets like the NASDAQ-100 Index, S&P 500, Dow Jones Industrial Average, etc. The main difference between ETFs and other types of mutual funds is that ETFs don’t try to outperform their corresponding index, but simply replicate its performance. They don’t try to beat the market. They only try to be the market.
Cost-efficiency and Tax-efficiency
Because an ETF tracks an index without trying to outperform it, it incurs fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than .20 percent per annum, as opposed to the over 1 percent yearly costs of some mutual funds. Because they incur low management and sponsor fees, and because they don’t typically carry high sales loads, there are fewer recurring costs to diminish your returns.
Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment.
Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies – because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.
All ETFs are subject to risk, including the possible loss of the money you invest. The key to a balanced ETF portfolio is creating the right mix of indexes. The most appropriate allocation is unique for each investor and is based on a range of factors. Among them is an understanding of your investment objectives and time horizon.
Mark S. Martel, CFP, is a local independent investment advisor and principal with Martel Wealth Advisors Inc. He can be reached at 360.694.9940. Securities and advisory services offered through KMS Financial Services Inc.