Should You Invest in ETFs?

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What is an ETF? How is it like a mutual fund? What to know before buying an exchange-traded fund.

In the olden days before the Great Depression, when the stock market worked with traders on the floor shouting orders at each other and little ticker tape scraps flying through the air, investing meant buying stocks and bonds.

Over time, the market grew and the available investment options became more complicated. People grouped stocks and bonds into funds and indexes. Then they sold shares in those. Pensions and 401(k)s came into the picture, investing in whatever they could to build retirement wealth for employees.

Where there's money to invest, there're people creating new investments to sell. Not everything you can buy these days is tied to one share of one business. For example: ETFs.

What is an ETF?

An ETF (short for exchange-traded fund) is a group of securities sold as a bundle. When those securities are stocks, the underlying ratio of these stocks tracks an index fund. ETFs represent the S&P 500 Index Fund, the Oregonian Index, or any other index you can imagine.

The price of a share of that ETF represents the value of the index. That price moves during the day with the prices of the stocks which make up that index. Just like a stock, you can buy or sell shares of that ETF throughout the trading day.

Unlike a stock, the transaction of the ETF can be easier. For example, the trading volume of the fund may be much greater than that of its member stocks, making it easier to buy and sell shares.

Because a stock ETF tracks an index, no one actively manages the contents of the ETF. No one's buying or selling individual stocks to try to get the best returns. Any gains or losses you make by investing in the ETF are the gains or losses of the underlying assets. Consequently, management fees are low, and much less of your potential profit gets eaten up due to trading costs.

ETFs Invest in Securities, Not Just Stocks

An ETF doesn't have to be tied to stocks. It could track precious metals such as gold and silver, real estate, international investments, or anything else you can imagine.

You can invest in these the same way you would a stock or a stock-based ETF, but it's more difficult to value the underlying investment with a value investing strategy, so there's little more to discuss on this point. They exist and may be worth your time.

What's the Difference Between an ETF and a Mutual Fund?

Mutual funds existed before ETFs. With a mutual fund, you pay fund managers a fee to invest all of the money in the fund at their discretion. The fund may have a philosophy (invest in small companies with growth potential, invest in specific industries, invest in ethical businesses), but any buying or selling happens when only the fund managers see opportunities.

This active management style allows really good fund managers to exploit great opportunities to produce amazing returns—but it will cost you. An ETF is cheap in comparison; you'll pay half a percent of invested funds. A mutual fund may cost two or three times that.

Mutual funds have stricter oversight by the SEC (partly because they can represent so much money) and other tax implications (due to the short nature of some of their investments). You can only invest in a mutual fund at the end of the day, when the fund has reconciled all of its investments. You can buy or sell an ETF any time during the trading day.

Why Buy an ETF?

If you find a great mutual fund manager, these limitations may not matter to you. You're investing based on the strength of someone else's ability to find good opportunities. If they are great and provide an amazing annual rate of return after taxes and fees, the additional price you pay and the reduced flexibility may be worth it!

If you're an individual value investor, remember that the opportunities available to a mutual fund manager with a $10 billion portfolio are very different from the opportunities available to the rest of us with less. A great stock like JCTCF—which the author of this piece currently owns—doesn't have enough liquidity for the former, while it can be great for the latter.

An ETF is easier to get in and out of (buy or sell at any time), cheaper (no management overhead), and easier to understand (it tracks an index).

Why Buy an ETF Instead of an Individual Stock?

If buying individual stocks is great), why would anyone buy an ETF? Two reasons: simplicity and safety.

Making an index fund the cornerstone of your investment strategy is conservative but wise. The best way to buy something like the S&P 500 is via an ETF such as VFINX. You get the benefit of diversity through the American economy across sectors and industries, the simplicity of buying only one fund as if it were a stock, and the low overhead of an ETF.

Better yet, you can buy into this fund at any time. You don't have to sit on the sidelines waiting for the stocks you track to go on a discount. If you make a regular habit of investing, you can even use dollar-cost averaging to ease your way into a nice nest egg.

You're probably not going to find a two, four, or tenbagger stock by investing solely in ETFs, but you will have found a nice, solid baseline for most of your money.

If you tie up all of your cash in an ETF, you'll have to sell some to free up money when you find a really good undervalued stock—with all the tax and fee implications there. Sometimes it's worth it, but sometimes it's worth having some cash free.

With that all said, an intelligent starting place for investing gives you a portfolio with most of your money in a couple of great index funds via ETFs and, optionally, leaves you some room to find great stocks on your own. If you're diligent and careful, you can parlay this into great wealth over time, partly by letting the American economy do what it does best and partly by finding great stocks on sale.

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