Exchange traded funds (ETFs) have emerged as a serious rival to the throne that mutual funds have long occupied. As they become more popular, investors need to be armed with information that helps them make the best decisions possible.
ETFs can safely be considered a threat to good ol’ mutual funds, as they can offer you instant exposure to a wide range of investments – from the broad stock and bond markets to individual sectors to niche strategies – all in one trade. Better still, ETFs are cheaper, more tax efficient and capital gains are rare. [ETFs: More Than a Mutual Fund Alternative.]
One of the main drawbacks to ETF ownership had been brokerage fees. Investors have had to pay commissions on trades made through brokers, explains Penelope Wang for CNN Money. Not anymore. A number of brokerages are now offering free trades on some ETFs and slashing the costs of trading on others. [Where You Can Go for Low-Cost ETF Trades.]
ETFs do, however, have some points of caution that investors should keep in mind:
- Getting Exotic. For many investors, it’s best to play it safe by sticking with broad-market ETFs where the bid/ask spread is normally narrow. The more narrow the sector that the ETF is tracking, the higher the expense ratio may be. If you want to buy an exotic ETF, be aware that it may be more volatile and watch the spreads when trading.
- Make Sure Your ETF is Tracking Its Index. The point of an index fund is for it to perform almost exactly as the benchmark does, since that’s what you’re paying for. Tracking error occurs in all kinds of ETFs for various reasons, but can be more pronounced in those that invest in less frequently traded securities. [How Tracking Error Occurs.]
- Careful with Commodities. While stock index ETFs are often tax-efficient, be aware that other types of ETFs, such as those that invest in commodity futures, can generate sizable taxable gains. Physical commodities are taxed at collectible rates, about 28%. [All About Physically-Backed Commodity ETFs.]
For more stories about mutual funds, visit our mutual fund category.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.