It used to be that mutual funds were the best choice for investors to save and grow their money. Today, exchange traded funds (ETFs) offer a very attractive alternative for investors, but there are some situations in which investors may be better-served by mutual funds.
Exchange traded funds, like index mutual funds, offer investors a variety of choices from which to invest in the market without having to choose specific stocks, reports Hans Wagner of Investopedia. Moreover, ETFs offer three unique cost advantages to mutual funds, although they also have two drawbacks. [ETFs vs. Index Fund Costs.]
The advantages are:
- ETFs tend to have lower expense ratios, which are management fees calculated as a percentage of a fund’s assets. Although the percentage differential is usually small, overtime, a small differential can become significant because of the power of compounding interest.
- ETFs, unlike mutual funds, do not require a minimum investment, save for the cost of a share in the ETF. This makes them more practical for small investors. [The Long-Term Costs of High Fees.]
- ETFs rarely generate capital gains. This is because of the creation/redemption process and the fact that, as index tracking products, there is generally lower portfolio turnover. [The ETF Creation and Redemption Process Explained.]
The disadvantages are:
- The transaction costs for buying and selling an ETF share can amount to a significant percentage of the total amount being invested. Like management fees, this will eat into your returns. [Financial Advisors Moving Into ‘ETF Mutual Funds.’]
- There is a spread between the buying and selling prices of shares, which also will eat into your returns.
- If you’re investing small amounts – say, less than $2,000 – you may be better-served by a mutual fund until you amass more. Because of transaction costs, dollar-cost averaging and ETFs tend not to mix. [ETFs to Keep Dusting Mutual Funds.]
The bottom line is that ETFs offer a very attractive way to make periodical investments. If the transaction costs of purchasing an ETF are too high, then it may be advisable to stretch out the purchasing period or increase the amount being invested to reduce the toll of transaction costs.
For more stories on ETFs, visit our ETF 101 category.
Sumin Kim 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.