ETF Center - Funds or ETFs

Since their introduction, exchange-traded funds (ETFs) have become a popular investment vehicle and the number of ETFs available has grown rapidly. One way to think of ETFs is as baskets of stocks, like mutual funds, but you can buy and sell them on the exchanges intra-day like stocks. Learn more about ETFs through the ETF Center, powered by Morningstar®. Once confident in your knowledge, as a Siebert client you can review our ETF Research, which includes an ETF Screener and Profiles from Interactive Data Corporation. Quickly review ETF performance data, holdings and other detailed information to help you make an informed investment decision.

Morningstar.com Logo Heed this basic advice to help you make the right decision.By Morningstar

Traditional open-end mutual funds have long been the staple of many investors' portfolios. Over the past 20 years, however, an alternative has emerged--exchange-traded funds. While ETFs have been around since the early 1990s, their popularity has soared in recent years, and they are being used by more and more brokers and financial advisors. In addition, ETFs are popping up in company retirement plans. Thus, individual investors--both do-it-yourself types and those working with an advisor--must now consider these new offerings alongside regular mutual funds when building a portfolio.

In this article, we'll discuss how to know whether a traditional mutual fund or an ETF is the better choice for you. ETFs--A Quick Primer ETFs, like conventional mutual funds, hold a basket of securities (stocks or bonds). The primary difference is how the investor buys and sells his or her shares. Whereas investors in conventional mutual funds buy their shares from a fund company and sell them back to the fund shop when they want to redeem, investors buying or selling ETF shares must trade with other investors in the market, much as they would do if they want to buy or sell shares of Microsoft (MSFT). For that reason, investors must use a broker when they want to buy and sell ETF shares. Only big institutions (like pension funds and Wall Street brokerages) buy and sell their shares directly with the ETF provider.

As the name suggests, exchange-traded funds are priced and traded on an exchange (AMEX, NYSE, or Nasdaq) throughout the day just like stocks. In contrast, traditional mutual funds' prices are set once a day (usually 4 p.m. Eastern) and investors must place their orders before that time in order to get that day's price. Also unlike mutual funds, you can do just about anything with ETF shares that you can with a stock, including setting market and limit orders, shorting, and buying on margin.

The fact that you must trade ETFs with other market participants means that an ETF will have two prices: Its net asset value, which is set daily based on the ending value of its portfolio and accrued expenses--just like a traditional fund--and its share price, which is determined by the ETF's supply/demand profile in the market, just like a stock. Typically, an ETF's share price will trade in close proximity to its NAV.

Choosing an ETF or a Traditional Mutual Fund So, how do you tell whether an ETF or a conventional mutual fund is the best bet for you? Here are some scenarios that might prompt you to consider an ETF:

You Want to Make a Focused Play on a Market Sector Exchange-traded fund providers have increasingly aimed to provide options for investors looking to invest in a narrow market segment. As noted above, you can trade ETFs throughout the day, but you cannot do so with mutual funds. Moreover, the ETF universe is flush with options that focus on a single market sector, industry, or geographic region. Currently, most ETFs are passively managed (that is, they track some benchmark just like a traditional index mutual fund), but creators such as iShares and others have opened up access to corners of the market not covered by open-end index funds. Say you favor indexing and want to own a specific corner of the market such as health care or telecom. There aren't enough, or any at all, index funds that track those sectors--but there are ETFs that do. Also, there are many more ETFs than funds that track single foreign countries. Exchange-traded funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks (plus, it's more cost-efficient in terms of brokerage commissions).

However, it's also worth noting that narrowly focused funds--whether ETFs or conventional offerings--can be too hot to handle for many investors. That's because investors are often inclined to buy and sell narrowly focused funds at inopportune times, as evidenced by Morningstar Investor Return statistics.

That's not to say that focused ETFs can't be used intelligently, however. On Morningstar.com, we often call attention to ETFs that are trading at discounts to the aggregate value of their holdings (based on Morningstar equity analysts' fair value estimates). If you're inclined to invest in more-focused ETFs, it makes sense to be a contrarian, not to chase what's been hot recently.

You're Concerned About Taxes ETFs, though not immune from taxes, are also structured to shield investors from capital gains better than conventional funds. Currently, most ETFs are index funds, so they typically trade less than most actively managed funds and should generate fewer taxable capital gains. Also, because most investors buy and sell ETF shares with other investors on an exchange, the ETF manager doesn't have to worry about selling holdings--thereby triggering capital gains--to meet investor redemptions. Moreover, because the big institutions can make share redemptions "in-kind" (rather than redeem shares for cash, the ETF gives the institution a basket of stocks equal in value to their share redemption), ETFs can unload their lowest-cost-basis stocks in the portfolio, thereby reducing their capital gains exposure. That said, given that an ETF portfolio mirrors its index, a change in the index's profile means a fund could incur capital gains as it re-configures its portfolio.

You're Concerned about Costs ETFs should also have appeal for cost-conscious investors who don't trade frequently. Multiple studies by Morningstar have shown that a fund's expense ratio is a reliable predictor of future success. And because ETFs don't have to manage hundreds of customer accounts or staff call centers, they have lower overhead charges that translate into lower expense ratios. On average, ETFs have a noticeable expense ratio advantage over the typical passive and actively managed mutual funds in many of the Morningstar categories.

Expenses, however, are just one part of the cost story. You'll also typically pay brokerage commissions to buy and sell shares, and the costs of rapid--or even occasional--trading can more than offset the initial advantage of an ETF's lower expense ratio. For example, assuming a return of 7%, someone who makes an initial investment of $10,000 in Fidelity Spartan 500 FUSEX (expense ratio 0.10%) and subsequent monthly contributions of $250 would have about $1,940 more at the end of 10 years compared with someone who followed the same plan with iShares Core S&P 500 IVV (expense ratio 0.07%). The funds invest in identical baskets of stocks, but the ETF investor would incur a brokerage commission each time he buys or sells, whereas the investor in the conventional mutual fund would not. (For our example, we assumed a brokerage commission of $12 to buy and sell the ETF.) However, it should be noted that some brokerages now offer commission-free ETF trades on a select set of exchange-traded funds, so it may be possible to invest in ETFs while keeping would-be brokerages fees in your pocket. But depending on the brokerage, your selection of commission-free ETFs may be limited.

For those reasons, an ETF will be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For most others, an exchange-traded fund isn't likely to have a big cost advantage over a plain-vanilla, low-cost index fund. ETFs may also be a suitable option for areas of the market where traditional mutual fund offerings are scarce, expensive, or run by managers with little experience. As in choosing traditional index mutual funds, it's best to evaluate an ETF's fees and the usefulness of the benchmark it tracks before buying in. ETFs and mutual funds have risks, charges and expenses, and you should carefully consider such risks, charges and expenses before investing. For a complete discussion of these risks, charges and expenses, and other important information, you should read the prospectus carefully. You can obtain a copy of the prospectus by calling Siebert's Mutual Fund Department at 800-872-0666 or contacting the ETF or mutual fund company directly.


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