The Benefits of Exchange Traded Funds

green plant in clear glass vase

ETFs Can Minimize the Downside of Investing, Yet Maximize the Upside

Easy Diversity

This may well be the single-biggest upside of ETFs. The idea of ‘safety in numbers’ applies to investment portfolios as well. An exchange-traded fund is by definition a collection of several (if not hundreds) of related stocks, so owning one ETF is the same as owning a small stake in each of those companies…without the mess of owning dozens of equities.

There are two basic ways ETFs can offer diversity.

First, if an investor simply wanted to mirror the market’s overall performance, an index-based exchange-traded fund would do the job. This idea is attractive to investors who don’t have the time or inclination to try and ‘beat’ the market by picking the next strong stocks or sectors.

Second, if an investor believes a portfolio’s sector allocation or style allocation is imbalanced, there’s not necessarily a need to try and pick a particular stock from the missing or lacking group. There’s most likely an ETF that mirrors the group as a whole.

Tax Friendly

Exchange-traded funds are the beneficiaries of what’s defined by the IRS as an ‘in-kind’ trade.

A manager of a traditional mutual fund sometimes will buy or sell stocks to pay for fund redemptions (or sells). These transactions are considered taxable events…..a tax liability passed along to the fund’s investors. All the owners of the fund are responsible for paying any due taxes resulting from those trades, whether or not those individuals actually sold any of their fund shares. If they did happen to sell any of their shares of the fund, then they’re responsible for any capital gains liability on top of the passed-through tax liability.

ETF managers, on the other hand, aren’t buying or selling any part of the portfolio to pay for redemptions…because ETFs are not redeemed. When you buy or sell an ETF, you’re buying from, or selling to, other investors; the underlying stock portfolio isn’t affected. The IRS calls it an ‘in-kind’ exchange. The only significant tax liability would be the capital gains created when the exchange-traded fund was sold.

There are sometimes minor taxable events for an ETF’s underlying stock portfolio, but they’re still considerably less than the ones created by regular mutual funds.

Trading Control

ETFs can be bought or sold at any time during the trading day. And, investors can always find a real-time quote at which the ETF can be bought or sold. It may not be the price the investor wants, but at least they can determine what the price is at the time

Traditional mutual funds, however, are only transacted once at the end of each trading day. Worse, mutual fund shares are not ‘priced’ until after the investor has committed to the transaction.

Low Operating Expenses

Investors never actually see or get billed for this, but portfolio managers of ETFs as well as mutual funds deduct a management fee for providing their service. The fee is paid with cash from the pool of funds that make up the underlying portfolio. In most cases, the management fee of exchange-traded funds is considerably less than traditional mutual fund management fees.

Relative Safety

See benefit number one again…safety in numbers. Though the common goal with exchange-traded funds is to achieve one-step diversity, the fringe benefit is that an ETF’s owners don’t have to worry about one poorly performing stock creating a major negative impact. That’s not to say an ETF can’t lose value, but they rarely plunge without warning the way a stock can.

The bottom line? As investment markets become more confusing and more turbulent, there’s a reason ETFs are becoming so popular. For the reasons cited above, individuals have found all of these benefits to culminate into one ultimate ETF upside…potentially better returns, with less stress.