What Are Exchange-Traded Funds (ETFs)?
An ETF is a security that tracks an index, such as the S&P 500, Dow Jones, or Nasdaq. Similar to stocks, ETFs are also traded on an exchange and brokerage fees and commissions would be owed for any order. When purchasing shares of an ETF, you are buying shares from a portfolio filled with a variety of assets from a particular sector (i.e. technology, industrial, etc.) that tracks the yield and return of its native index. Remember, an ETF tracks an index without trying to outperform it – rather than beat the market, it becomes the market.
The 5 Main Benefits Of ETFs:
Here’s the main benefits for investing in ETFs:
Convenient investment vehicle for people to purchase a variety of broad securities in a single transaction.
Offers the diversification of a mutual fund but with the convenience, flexibility, and liquidity of stocks.
Low costs compared to other funds because most ETFs are not actively managed with no front and back-end loads.
ETFs are redeemed as stock instead of cash, thus allowing investors to defer capital gains tax until those stocks are actually sold.
Historical data concluded that major indexes consistently outperformed actively managed portfolio funds, thus making it an attractive buy-and-hold investment for long-term growth.
Total Cost of ETF Ownership:
Before purchasing any ETF, it’s vital that you know the estimated “total cost of ETF ownership,” especially since it could negatively impact your ROI:
Brokerage Fees / Commissions – The amount of brokerage fees and commissions paid for each trade / transaction.
Spreads (Bid vs. Ask) – The difference between the lowest seller’s ask price and the highest buyer’s bid price.
Operating Expense Ratio (OER) – An ongoing cost that’s charged to shareholders annually for the management of the portfolio.
Holding Period – Estimated timeline for holding the ETF in your portfolio.
To determine the annual total cost of ETF ownership, you could use the following general formula:
Operating Expense Ratio (OER)
+ Bid-Ask Spread years you plan to hold the ETF
+ 2 dollar commission $ amount of investment years ETF will be held
To illustrate, let’s say that your selected ETF has a $10K investment with an OER of 0.10%;. If you plan to hold this ETF for 6 months with a 0.15% bid / ask spread and the trade commission was $8.95, the annual total cost of ownership is 0.76%. See calculations below:
+ (2 8.95 10,000) 0.5
0.76% per year
Your objective should be to select ETFs that not only encompasses broad market indexes with a proven track record of strong performance but also funds that have low fees and commissions. The goal is to keep your annual total cost of ownership as low as possible in an effort to maximize your ROI.
In the end, I’m amazed to witness the evolution of ETFs. In 1993, the first ETF called “SPDRs (Standard & Poor’s 500 Depository Receipts)” was traded in the United States. Fast forward twenty years and the popularity of ETFs has grown to approximately 1500 and the market is expected to double by 2016. In fact, the influx of ETFs has paved way to higher competition and lower fees, thus making it a great time to invest in ETFs.
To help you get started, here are some of the more popular ETFs that you may want to consider…
VANGUARD MEGA CAP 300 GROWTH ETF (MGK) – Replicates the faster growing half of the MSCI US Large Cap 300 index.
VANGUARD DIVIDEND APPRECIATION ETF (VIG) – Invests only in organizations, such as Procter & Gamble, that not only have strong balance sheets but also companies who raised their dividends for the past 10 years.
MARKET VECTORS MORNINGSTAR ETF (MOAT) – Morningstar’s picks (100) with strongest barriers to entry against competitors, hence it’s name.
VANGUARD MSCI EMERGING MARKETS ETF (VWO) – Invests in reputable companies in the world’s fastest-growing economies.
Hopefully after reading this post, you’ll have a better grasp on ETFs to the point where you’re not shunning away from this lucrative investment vehicle.