What is an Exchange Traded Fund? (Psst… It’s a Pretty Simple Way to Invest for Retirement)
ETFs have become very popular investment vehicles and they can be a good place for retirement savings. In a nutshell, ETFs can be a low cost way to insure adequate diversification for retirement assets.
But what is an ETF really?
What is an ETF?
ETFs are often defined as a mutual fund that trades like a stock and this is a good way to think about ETFs — assuming you have a crystal clear understanding of mutual funds and stocks.
Perhaps a comparison of mutual funds, index funds and ETFs will help clarify how each investment works:
Mutual Funds: Mutual funds are a way to invest in a portfolio of different investments — usually stocks, but a fund could also include bonds and other types of securities.
Typically, mutual funds are managed by a professional advisor and the idea is that this expert can buy and sell investments to get investors the best return for their money.
The goal of most mutual funds is to outperform a widely followed index like the Standard & Poor’s 500. So, if the Standard & Poor’s 500 saw a 1% increase, the mutual fund would want at least a 1.1% increase.
Most mutual funds charge fees, usually around 1% of the assets you have invested in the fund annually.
Index Funds: An index fund is a kind of mutual fund designed to mimic the rise and fall of an overall market index. The most popular index funds track the Standard & Poor’s 500.
An index fund typically buys and holds rather than trades frequently.
And, the reality is that these index funds often offer better returns than a professionally managed mutual fund.
ETFs: ETFs are very similar to index funds in that they enable you to invest in a preset group of investments — often an index. The difference between an ETF and an index fund is the way they are traded. You can purchase an ETF in the same way you purchase stock and the costs of ETFs can be quite low.
Explore some of the benefits of ETFs below.
Benefit of an ETF: Diversification
One of the key goals of any good asset allocation strategy is diversification — being invested in a variety of asset classes and a range of companies within each asset class.
ETFs can be the ultimate in diversification, allowing you to have a broad exposure.
Benefit of an ETF: Transparency
With most ETFs, investors can see the underlying portfolio daily. Mutual funds are only required to report their holdings a couple of times during the year.
Benefit of an ETF: Trade Like Stocks
Just like individual shares of stock, ETFs can be bought and sold during the day while the stock exchange is open. Mutual fund orders must be submitted before the close of the market (earlier in the day for some funds) with the purchase or sale occurring after the close of trading for that day.
While there are distinct disadvantages to day-trading and market timing, it is nice to be able to get in or out of an ETF as needed.
This also means that market orders such as stop orders, limit order and others can be placed on an ETF to trigger a trade if the price hits a certain level (up or down). This is same as with shares of individual stocks. ETFs can also be sold short, a bet on a price decrease.
Benefit of an ETF: Cheap to Own
Many ETFs are very cheap to own. This is especially true with a number of index ETFs such as:
- Vanguard Total Stock Market (ticker VTI) has an expense ratio of 0.04%.
- Spider S&P 500 Index ETF (SPY), one of the oldest and largest ETFs has an expense ratio of 0.09%.
This can make low cost ETFs a good idea for long-term investors and a good vehicle for retirement investing. Fees and expenses are a critical factor in your long-term investing success and low-cost ETFs can play a role. Of course, not all ETFs are low in cost, you will need to research this and other aspects of any ETF that you may be considering.
Benefit of an ETF: Liquidity
Liquidity pertains to the ability to readily trade a security at or near its market value. ETFs have built-in liquidity via their listing and the ability to trade them on the stock exchange. ETFs that have a high daily trading volume and that track popular indexes like the S&P 500 will not have an issue with liquidity.
Some asset classes, such as bonds, are not as liquid as large cap domestic stocks. For bonds and other asset classes such as commodities, real estate and some foreign securities, ETFs provide a level of liquidity that might exceed the liquidity inherent in trading these types of securities individually.
As an example, bonds trade on an over-the-counter basis and the secondary market for them is not as well-defined as that for stocks. Bond ETFs have provided fixed income investors a degree of liquidity that was not always available to them.
Benefit of an ETF: Go Beyond Indexes
Passive index ETFs tracking benchmarks like the S&P 500, the Russell 1000 and 2000 indexes, the Barclays Aggregate Bond Index and other widely followed stock and bond indexes are probably the most prevalent types of ETFs.
However, with interest in ETFs on both the part of the investing public and institutional investors, the number of types of ETFs have proliferated. There are now ETFs that:
- Are actively managed.
- Follow alternative investment strategies.
- Are comprised of bonds
- And more…
One of the areas of growth in ETFs in recent years is in smart beta ETFs. Essentially these are ETFs that start with an index, but then specialize in a specific investing goal or type of company. Common types of smart beta ETFs include:
- Dividends — companies within an index that are more likely to pay out dividends
- Quality Momentum
- Size (for example small cap)
- Low volatility
- And others
Should I Consider an ETF as Part of My Retirement Plan?
The answer to this question will vary by person and will depend upon your objectives and other considerations that should go into the selection of any investment vehicle for retirement. Any ETF that you might be considering should be fully evaluated for its fit with the rest of your portfolio and in light of your investment objectives.
While there are some ETFs of bonds and other fairly stable investments, most ETFs are still essentially well diversified investments in the stock market, which is not without risk. If you own an ETF that tracks the Standard & Poor’s 500 and the entire market crashes, then your ETF crashes as well.
ETFs can be a great long-term investment vehicle for retirement or any other objective. Many index ETFs are low-cost and have a straightforward investing style. However, you want to:
- Know what is in your ETF
- Consider carefully how much exposure you want to various asset classes. (Learn more about the bucket strategy as a way to optimize your investment risk and reward for retirement.)
Smart beta and other ETFs can also be appropriate or even a great option for some of your retirement investing goals, but may take a bit more analysis.
ETFs can be mixed and matched with mutual funds, individual stocks, bonds or any other investment vehicle in building a portfolio. Retirement investors can certainly consider ETFs if appropriate for their needs.