Many who visit this site may already be well aware of what exchange traded funds (ETFs) are. But as evidenced by all the new money pouring into them, many investors are just starting out on their journey with ETFs. It’s worth revisiting the basics, whether you’re a newbie or an old hand.
Exchange traded funds (ETFs) are baskets of securities with an underlying index that trade all day on an exchange like a stock. They’ve been around since 1993. The first ETF, the SPDRS (NYSEArca: SPY), tracked the S&P 500. The strategy of indexing is not new, however. Barclay’s created it in 1971.
Some of the advantages of ETFs include:
- You always know what you’re buying, because they replicate indexes. The holdings of those indexes are easily available and posted daily.
- ETFs offer safety in numbers. They have more diversification because they’re a basket of stocks rather than one individual stock.
- Their performance can be easily tracked.
- ETFs tend to have lower expenses and fees because they passively track indexes. There are no additional fees to pay to a fund manager. The average fee for a mutual fund is about 1.6%, while for a large-cap growth ETF it’s about 0.15%.
- They’re tax efficient because investors rarely generate capital gains.
It’s easy to trade ETFs. Esko Mickels for Morningstar compiled a list of tips all ETF investors should have under their caps, and we tossed in a few bonus ones of our own, as well:
1. Timing the trade: Be careful buying and selling ETF during the first and last 30 minutes of the day. An ETF’s volatility is highest at those times and wide spreads are more common.
2. Exercise caution on volatile days: Volatile days in the market can throw an ETF’s underlying value off of its bid-ask spread, so tread with caution.
3. Limit orders: Use these to define the price you’re willing to pay, thereby limiting your market impact. Read more on limit orders here.
4. Select ETFs with high trading volume: While high volume doesn’t necessarily equal liquidity, it implies that a limit order for a few hundred shares near the current mid-market price should be filled quickly. These also remain closer to their NAV.