5 misconceptions I had about ETFs

What are ETFs?

If you know about mutual funds, then an ETF will be familiar. ETF stands for exchange-traded fund. It’s similar to a mutual fund except it’s traded on an exchange like a stock. Since you can buy and sell shares throughout the day, you can see the real-time price of the ETF anytime. ETFs and mutual funds are similar in many ways. Just as there are index mutual funds, there are index ETFs. Index funds—both mutual funds and ETFs—are passively managed funds that seek to match the performance of an underlying index. An S&P 500 index fund tries to match the performance of the S&P 500 Index, and it’s one of my favorite passive income investments. There are many misconceptions about ETFs—I know because I believed a lot of them, and today we’ll dispel some of the biggest.

1. ETFs are more volatile

I’m a firm believer that you should buy and hold stock investments for the long term. A mutual fund, especially a low-cost index fund that only transacts once a day, feels stable. Why would I want an ETF that has its shares bought and sold all day? I don’t want to watch the price change by the minute. An ETF is just a fund that holds a basket of stocks and bonds that move up and down throughout the day. A mutual fund does the same thing. The only difference with a mutual fund is that you only see price changes once a day after the market has closed. The value of the mutual fund’s shares change throughout the day, as its investment holdings’ values change—you just don’t see it. An ETF isn’t inherently more volatile just because you can trade it. It only feels that way because you see the price in real time. An ETF’s volatility is based on the securities it holds—if it tracks the same benchmark as a mutual fund, the volatility will be comparable.

2. ETFs are “copies” of mutual funds

I thought all ETFs were exchange-traded versions of existing mutual funds. For the first two decades, this was mostly true. ETFs were all based on existing benchmark indexes like the S&P 500 and Russell 2000. Most ETFs are index funds, but you can get ETFs with a wide variety of investment strategies. There are ETF versions of your favorite index funds, like the S&P 500, as well as bond and stock funds. You can buy ETFs by asset type or sector, like a health care ETF that seeks to match the performance of the broad industry.

3. ETFs are more expensive

Buying and selling ETFs can be more expensive because they’re bought and sold like stocks. Each transaction may be subject to a commission, which is a fee you may have to pay your broker. However, many brokers that offer ETFs let you buy and sell some ETFs without paying a commission. (Learn more about Vanguard ETF® fees and minimums.) When a brokerage firm offers commission-free ETFs, it levels the playing field with mutual funds. Commissions aside, when it comes down to it, an ETF is like any other financial product—its price varies. An ETF isn’t inherently more expensive than a mutual fund with the same investment objective that tracks the same underlying index. I was surprised to discover that, in some cases, an ETF may actually have a lower expense ratio than a similar mutual fund. (An expense ratio is the total percentage of fund assets used to pay for administrative, management, and other costs of running a fund.) It’s also worth mentioning, there’s no required initial investment to own an ETF—if you have enough cash to buy a single share, you can start investing. Mutual funds, on the other hand, may require an initial minimum investment of $1,000 or more.

4. ETFs are less tax-efficient

ETFs are bought and sold throughout the day on an exchange, just like stocks. I thought this frequent-trading activity made them less tax-efficient. In reality, it doesn’t. The shares of an ETF may change hands, but the underlying assets don’t. When you buy and sell shares of a mutual fund, the mutual fund’s underlying assets change, and the fund must buy and sell securities to reflect this. If there’s a significant flow of money in either direction, the mutual fund buys or sells the underlying securities to account for the change. This activity can create a taxable event. If a mutual fund sells a security for more than its original price and realizes a net gain, you (the investor) are subject to capital gains tax plus the taxes you may owe when the fund makes a distribution, such as a dividend payment, to your account. On the other hand, when you buy and sell shares of an ETF, the ETF doesn’t have to adjust its holdings, which could trigger gains and losses. While an ETF buys and sells its underlying securities as needed, outside forces don’t affect an ETF as easily as a mutual fund. This makes an ETF more efficient under the same circumstances.

5. All index ETFs are created equal

If you want to buy an S&P 500 ETF, you have many options. Vanguard S&P 500 ETF (VOO), iShares Core S&P 500 ETF (IVV), and SPDR S&P 500 ETF (SPY) are all ETFs that seek to match the performance of the S&P 500® Index. They’re not all priced the same, however. If you review their expense ratios, you can see a big difference. More importantly, if you compare the year-to-date performance of each ETF, they may not match exactly. They may not even match the performance of the benchmark index, the S&P 500. This difference is known as tracking error. ETFs use different approaches to match what they track. With an index, most ETFs buy the stocks in the index at the proper weightings. As the components or weightings of the index change, the ETF adjusts accordingly, but not instantaneously. This may lead to a difference in the returns based on how quickly the ETF adjusts. You might think a positive tracking error is a good thing because the fund’s return is higher than the underlying index. A slight difference is acceptable, but you don’t want a large disparity. The goal of investing in an index fund is to mirror the returns of the underlying index given its risk profile. If the fund’s holdings no longer match its respective index, you may be exposed to a risk profile you didn’t sign up for. It’s important to review the ETF’s expense ratio and tracking error before selecting the ETF you want.

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