Welcome to your “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.
Today’s question is about investing in exchange-traded funds, also known as ETFs. They have become one of the most popular ways to invest in stocks, bonds and other securities, attracting many billions of investor dollars. And there’s a good reason why: They allow small investors to put money in the markets easily and inexpensively.
Want to know more about ETFs? Watch the following one-minute video, and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript to find out what I said.
You also can learn how to send in a question of your own below.
For more information on this topic, check out “How to Get Started Investing With $500 or Less” and “12 Money Facts That Everyone Should Know in 2019.” You can also go to the search at the top of this page, put in the word “invest” and find plenty of information on just about everything relating to this topic.
Got a question of your own to ask? Scroll down past the transcript.
Don’t want to watch? Here’s what I said in the video
Hello, everyone, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson. You ask a money question, I answer it quickly.
Today’s question comes from Gary:
“Is it wise to purchase exchange traded funds (ETFs)?”
Before we answer Gary’s question, let’s explore the differences between two similar investment vehicles: mutual funds and exchange-traded funds.
Understanding mutual funds
You’ve probably heard of mutual funds. A mutual fund is a way to pool your resources with other investors and own a small slice of a bunch of stocks (or bonds, or both), instead of a bigger chunk of just a few. It’s one of the fundamentals of finance: safety through diversification.
A mutual fund also allows you to hire a company to help with the paperwork, as well as professionals who are theoretically smarter than you when it comes to knowing what to buy and when to sell it. Since these management fees are spread among thousands of investors, they’re more affordable.
Fund management can also be active or passive. Active managers study companies, then pick the stocks or bonds they think will perform best. A passive manager just picks stocks to mirror an index, like the S&P 500. As you might imagine, picking the stocks in an index is easier than figuring out what to buy and sell. That’s why actively managed funds typically charge a larger management fee than passively managed index funds.
According to research firm Morningstar, the average annual management fee for actively managed funds in 2018 was 0.67% of assets. Passive funds’ fees averaged 0.15%.
Mutual funds may also have a built-in commission, known as a load, when you buy or sell. If they feature a commission, they’re called load funds. If they don’t, they’re called no-load.
To summarize: A mutual fund allows you to spread your eggs among many baskets and hire professionals to watch them. Mutual funds make a lot of sense, which is why they’ve been around a long time: since 1924.
Drawbacks of mutual funds
A mutual fund is valued only once per day. After the market closes, the fund manager adds up the closing values of all the securities in the fund, divides it by the number of shares outstanding, and there you have it: your price per share. If you buy today, that’s what you pay. If you sell today, that’s what you get.
It’s a simple system — it had to be in the days before computers — but there’s a potential fly in the ointment. Namely, what if you want to buy or sell in the middle of the day? What if the market is falling and you want to get out before it falls more? Or it’s rising and you want to get in before it goes up more?
When you trade individual stocks, you can buy or sell any time the market’s open and if you choose, you can name the price you’re willing to pay or accept. But with a mutual fund, you place your order while the market is open, but you don’t know the price you’ll get until after the market is closed.
ETFs to the rescue
In 1924, there was no way to maintain split-second values throughout the trading day for the hundreds of stocks in a mutual fund. But by 1993, computers made these calculations simple, and the exchange-traded fund was born.
As the name implies, exchange-traded funds, or ETFs, are simply funds that trade on a stock exchange. Like a mutual fund, they’re a diversified portfolio with professional management. Like a stock, you can buy as little as one share in a few seconds any time the market is open. You can also choose the price you’re willing to accept.
So, an ETF is simply a mutual fund/stock hybrid.
ETFs also tend to have lower expenses than traditional mutual funds. According to Morningstar, the average expense ratio for passively managed ETFs in 2018 was 0.57%. Actively managed ones, 0.76%. Both of those costs are significantly lower than those of the ETF’s mutual fund cousins.
ETFs do have at least one drawback relative to mutual funds, however: As with a stock, you’ll typically pay a commission to buy or sell shares. I say “typically” because there are now a lot of ETFs that are commission-free.
Which is better?
Now, let’s revisit Gary’s question: “Is it wise to purchase exchange-traded funds (ETFs)?”
Answer? Absolutely, Gary!
ETFs are a great, low-cost way to buy, own and sell diversified groups of stocks and/or bonds. But traditional mutual funds can be OK as well.
If you’re going to trade; i.e., buy and sell often, ETFs are better than mutual funds because you can get in and out easily. But if you’re going to invest for the long term (the only kind of investing I endorse) either will work. The key is to find funds that invest in the right type of securities, perform well and have low costs.
My advice for beginning investors? Start with an S&P 500 Index fund or ETF from Vanguard. The Vanguard ETF has one of the lowest expense ratios in the business: 0.03%, versus 0.14% for the mutual fund, so that’s probably the way I’d go. Take a minute and compare them both here.
Hope that answers your question, Gary, and I’ll see you all right here next time!
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I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.
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