ETFs are taking off and for good reason
I was bowled over this summer when I read that the amount invested in exchange-traded funds (ETFs) in the U.S. market has surpassed $4 trillion. I know, I know, I should have been at the beach. But I was indoors, reading the paper—the financial section, even. You got me!
This kind of investing-wonk development is why I never get bored writing and talking about personal finance. There are always new wrinkles. Only this was more like a giant crease. And if you missed this milestone (perhaps because you were collecting seashells), let me fill you in.
ETFs are a (relatively) new type of investment that took a (relatively) long time for individual investors to adopt. After they were introduced in the early 1990s, nearly a decade went by before investments in ETFs reached the $1 trillion mark. But in recent years, they’ve exploded. (For comparison, there’s about $18 trillion in mutual funds, a much older and more established type of investment.)
Why should you care? Let me explain.
First off, let’s talk individual stocks. When you buy a stock, you are buying ownership in one company. But when you buy a stock fund, like an index fund or ETF, you are buying a collection of many stocks at once. So, rather than place a bet on the performance of just one company, you’re spreading your risk around. Like index funds, ETFs come in two flavors: actively managed (meaning there’s a manager picking stocks) or passively managed (meaning it’s simply invested in the stocks that make up an index, such as the S&P 500). Passive investments, especially index funds and index ETFs, are my favorites because they charge lower fees than—and have historically performed as well as or better than—their active cousins.
During the Great Recession, a lot of investors started turning to index ETFs for their low cost and relative safety, and their popularity took off. So why should you consider going with an ETF?
- ETFs are often even cheaper than index funds. Vanguard, the company that popularized low-cost index funds, charges an expense ratio of 0.03% for its S&P 500 index ETF—even less than the 0.04% it charges for its S&P 500 index fund. But not all index ETFs are created equal: Some brokers charge one-time commissions when you buy one, so make sure to read the fine print.
- ETFs allow you to start small. The entry price to invest in an index ETF is the cost of one share, often $100 or so—lower than that of many index funds, which tend to require minimum investments of thousands of dollars. A single share of Schwab’s “broad market” ETF is currently under $100, while the Vanguard version costs about $150. If you’re looking to invest but don’t have a lot of money to spare, ETFs are an excellent choice. (Note: I don’t get any kickbacks or commissions for mentioning financial products on my site.)
One caveat: ETFs are more tempting to trade. Unlike an index fund, whose price is recalculated only once a day, an ETF’s price can fluctuate throughout the day. That difference makes it easy to think of ETFs as individual stocks to be bought and sold when the timing is “right.” But if you’re a buy-and-hold investor—which you should be, since studies show that more frequent trading often leads to lower returns over time—this difference is merely academic, and won’t affect you.
Like the sound of index ETFs? I say this is one time when following the crowd is the way to go.