Exchange Traded Funds

What are Exchange Traded Funds (ETFs)?
ETFs - Similar to Index Mutual Funds, but Not
What is an ETF? In short, they are similar to index mutual funds, but are traded more like a stock. As their name implies, Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an exchange. As with all investment products, exchange traded funds have their share of advantages and disadvantages.
Advantages of Exchange Traded Funds
Being similar to stocks, exchange traded funds offer more flexibility than your typical mutual fund.
ETFs can be bought and sold throughout the trading day, allowing for intraday trading - which is rare with mutual funds.
Traders have the ability to short or buy ETFs on margin.
Low annual expenses rival the cheapest mutual funds.
Tax efficiency - due to SEC regulations, ETF tend to beat out mutual funds when it comes to tax efficiency (if it is a non-taxable account then they are equal).
Disadvantages of ETFs
Unfortunately, exchange traded funds do have some negatives:
Commissions - like stocks, trading exchange traded funds will cost you.
Only institutions and the extremely wealthy can deal directly with the ETF companies (must buy through a broker).
Unlike mutual funds, ETFs don't necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolios.
Slippage - as with stocks, there is a bid-ask spread, meaning you might buy the ETF for 15 1/8 but can only sell it for 15 (which is basically a hidden charge).
The Bottom Line
After comparing the advantages and disadvantages to using ETFs, you might conclude that they are a better deal than mutual funds - not true. Commissions make ETFs unattractive. If your portfolio is a tax deferred investment, like a 401(k) or an IRA, then you can avoid paying commissions by investing directly with a mutual fund company. Even in a taxable account, commissions make exchange traded funds look bad.
Morningstar provides a great example: a lump-sum investment of $10,000 in the iShares S&P 500 Index, with a very low trading cost of $8, would need to be held for two years to beat out the Vanguard 500 Index's costs. If you are investing less than $10,000 and are paying more than $8 commissions, or you are investing more than once, this example would make ETFs look much worse.
Investing directly with a mutual fund company generally beats out ETFs, especially in these situations:
Non-taxable accounts
Small investments - if you invest a certain amount each month or are on some sort of automatic investment plan (ETF commissions would kill your investment).
Active traders - although ETFs are primarily geared towards active traders, an active trader might be better off with mutual funds which don't charge commissions (most mutual funds discourage active trading, but some, like Rydex, Profunds and Potomac Funds encourage it).
When to Use Exchange Traded Funds (ETFs)
Discover When ETF Investing Make the Most Sense
In What Are Exchange Traded Funds I list the differences between exchange traded funds (ETFs) and mutual funds. In many cases mutual funds are still the better choice, but in some situations ETFs are the right choice. Let's explore those situations.
Lump Sum Investment
One of the biggest advantages of mutual funds, is the ability to purchase them without trading costs. However, if you have a large amount of money to invest, perhaps from an inheritance or a 401(k) rollover, trading fees may be of little concern to you. A $15 commission on a $100 investment is catastrophic (a 15 percent hit), but on a $100,000 investment, it isn't bad at all.
Market Timing
If you are a market timer, ETFs may be a pleasant surprise for you because you can trade them intra-day. ETFs also allow you to trade certain industries, countries, and indices that may not be as easily available in the fund or stock markets.
Ever since mutual funds came under fire because a few fund companies allowed market timers to cheat the system, timing mutual funds has become more difficult. Mutual fund companies have placed more restrictions or penalties on short-term trades than ever before. ETFs are a way to avoid these restrictions because they are traded like stocks.
Despite the market timing appeal of ETFs, there are a couple fund companies you should consider before you jumping in. Both Rydex and ProFunds allow intra-day trading on their index funds. I suggest you look at them first.
Taxable Investments
One disadvantage of mutual funds is that they must pay distributions at the end of the year, per IRS rules (see Capital Gains or Capital Punishment). ETFs get around this. However, when you sell your ETF, it is subject to normal IRS capital gains rules (remember, ETFs trade like stocks).
Bottom Line
Generally, mutual funds are the better choice, but in the situations like these, an ETF might serve you best. Even though my site is primarily focused on mutual funds, I realize the opportunity and convenience that ETFs offer. I admit to owning a few myself.