Diversify, diversify, diversify: This is the message individual investors hear more than any other. Thanks to an explosion in the number of mutual funds and exchange-traded funds (ETFs), diversifying your portfolio has never been easier.
Because they pool investors’ money to invest in baskets of stocks, bonds or other securities, ETFs and mutual funds are sort of a shortcut to diversifying your portfolio across a variety of assets and asset classes. You can now choose among 7,677 different mutual funds and 832 individual ETFs, according to the Investment Company Institute (ICI).
So where should you put your money? Mutual funds or ETFs? Well, that depends. The masses are sticking with mutual funds. In February alone, investors put $87 billion into mutual funds, compared to only $19 million into ETFs, according to ICI.
If you want more flexibility along with your diversification, however, you should take a closer look at ETFs, which have a few distinct advantages over mutual funds. Keep in mind, some of the investing strategies described below are fairly sophisticated and may not be for everyone. If you subscribe to the “buy and hold” investment philosophy and don’t plan to engage in daily trading or market-timing, focus on the first two points in order to make a decision whether ETFs make sense for you.
(Should you decide to build an ETF portfolio, on the other hand, this series of videos should help you get started.)
ETFs Are More Tax Efficient
Because of the way most ETFs are managed, they are very tax efficient. Typically, when you own an ETF, your capital gains tax liability will occur when you sell the fund rather than while you own it. That puts you in control over when and how taxes will be paid. The less you pay the tax man, the more you get to keep for yourself: a clear advantage for those who manage their ETFs portfolios in a way to keep their tax liability at a minimum.
By contrast, most mutual funds buy and sell stocks often, accumulating a tax liability that they pass on to their shareholders (i.e. you). That tax liability, also known as a capital gains distribution, could become quite large if one or more major holdings were all sold at the same time. And this doesn’t only affect investors who owned shares of the fund at the time those trades were made: investors who bought shares afterwards also share in that liability. Actively managed mutual funds can be even worse from a tax perspective because they trade much more often.
ETFs Have Lower Costs
The average mutual fund charges a combination of several fees that can total 1.3-1.5% of total assets under management. (Often twice as much for actively managed funds.) To put that in easier terms, if you had $10,000 invested in a typical mutual fund that charged 1.3% of assets you would be paying $130 a year in fees. These fees are charged whether the fund goes up or down in value. Over time, these fees can eat up a significant portion of your total portfolio.
ETF fees, on the other hand, can be as low as 0.18% to 0.20% of assets. The costs are low because most ETFs are pegged to an index (as opposed to actively managed), so there are no fund managers and other administrative staff to be paid.
ETFs Allow Stop Losses
ETFs trade in the open market just like stocks–which means you can buy or sell them anytime during market hours. If you want to buy or sell a mutual fund, on the other hand, you have to wait until the market closes for the day before you can enter or exit your trade.
Because you can trade ETFs anytime during market hours, you can place stop-loss orders on your trades. A stop-loss order is conditional trade you place ahead of time that gives your broker instructions to automatically sell your position if the price of your ETF drops below a specified price in the future. Think of it as insurance against sudden price drops. Even if you are not watching your portfolio at the time the market tanks, your broker will automatically take you out of your trade–saving you from further losses.
ETFs Are Shortable
Mutual funds give you a great way to diversify across asset classes you are bullish on, but they don’t do much for you if you are bearish. ETFs, on the other hand, work well for both bullish and bearish investors.
Since ETFs trade just like stocks, you are able to short an ETF just like you would a stock. When you short a stock or an ETF, you make money if the price of the stock or ETF goes down, and you lose money if the price goes up.
How it works: you borrow shares of an ETF from your broker with a promise to return them on a specified date in the future. Once they’re in your account, you immediately sell those shares in the open market. At some point, you will have to go back into the open market and buy back the same number of ETF shares that you sold, but the hope is you will be able to buy those shares back at a lower price and pocket the difference.
For example, if you sold shares of the SPDR S&P 500 ETF (SPY) short at $115 per share and then bought them back again after the price had dropped to $100 per share, you would make $15 per share ($115 – $100 = $15).
ETFs Have Options
Perhaps the biggest difference between ETFs and mutual funds is that many ETFs are “optionable.” That means you can buy and sell call options and put options that are based on the underlying stock or ETF–which opens up a world of trading strategies you simply can’t use with mutual funds.
One option strategy ETF traders are particularly fond of is covered calls (sometimes called call writing). When you own a mutual fund and it starts trending sideways, there isn’t much you can do to make money with that mutual fund. You just have to sit and wait and hope it starts to increase in value.
When you own an ETF and it starts trending sideways, on the other hand, you can sell a call option on that ETF and bring in some extra cash while you wait for the ETF to start moving higher again.
Confused? Here’s an example:
Imagine you own 100 shares of the SPDR Dow Jones Industrial Average ETF (DIA). If you sell a DIA call option, you are giving someone the right to buy your 100 shares at a specified price before a predetermined date in the future. In exchange for this right, the person who buys the call option from you pays you a premium that you get to keep, no matter what.
Keep in mind that you get to choose the specified price (strike price) at which you will sell your 100 shares when you sell the call option. In a situation like this, you would typically choose a price that is higher than the current trading price of your ETF. And if the price of the ETF never reaches that price, you get to keep your 100 shares plus the premium you received from the call-option buyer.
If the price of the ETF does rise above the strike price before the predetermined date (expiration date), you may have to sell your 100 shares, but you still get to keep the premium.
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