I’m looking at making some investment for my Roth IRA and everything seems to point to ETFs considering:
No trade fees and lower expense ratio
Tax implications are non-existent (actually this favors mutual funds)
Trades as an equity (but this doesn’t matter since one I buy, I leave it)
So I’m being told that for what I want to do basically an ETF is just like a mutual fund but I can’t shake the feeling that there’s a fundamental difference between investing in an equity vs. mutual fund in terms of how it grows. For example:
If I invest in a dividend mutual fund, I believe I get the dividends and then I reinvest it into more of the fund. How do dividends work in a dividend ETF?
The NAV of a mutual fund is based on the value of the stocks held. The equity price of an ETF mimics the NAV of the underlying fund (given supply v demand of the actual ETF) but how does the price of the ETF grow due to the growth of the corresponding mutual fund’s NAV?
You get the dividends in cash (i.e. some cash just shows up in your brokerage account periodically). Like regular mutual funds, the dividends originate as dividends of equities that the mutual fund holds, and the fund aggregates them and doles them out periodically.
Hereis a dividend history of SPY, which is one of the archetypical ETFs.
Most ETFs have a completely known portfolio and at any time large financial institutions can exchange baskets of that portfolio for units of the ETF or redeem units of the ETF for baskets of that portfolio. This means that if the price of the ETF falls out of line with the price of the portfolio, arbitrageurs can step in and buy or sell the ETF and then sell or buy the portfolio to make free money until the balance is restored.
I think you are overthinking the difference between standard mutual funds and ETFs. Functionally ETFs are very similar to standard mutual funds, except for the way they are traded, and the fact that their fees are typically (but not always) a lot cheaper than standard mutual funds.
The value of a mutual fund is determine after the market close each day. You buy and sell at that price. An ETF is traded during the day, with the price adjusted constantly by the market. Thus it has a bid/ask spread like a stock.
Also, your comparison really should be to a mutual fund which is an index fund. A mutual fund which does not track an index is more fairly compared to a closed end fund (CEF) with a similar strategy.
Market traded funds have the added feature that they may trade at premium or discount to their net asset values, which does not apply for mutual funds.
It sounds like you already know most of the differences between mutual funds and ETFs so I’ll just tell you the main reason to pick one or the other.
If you plan to buy a large dollar amount once every year or so then go with the ETF. They have lower expense ratios and other advantages. If you stick to the big ETFs such as SPY or QQQQ then the bid/ask spread won’t be a issue.
If you plan to buy a set dollar amount every set time period (for example $400 every month) then go with the mutual fund. They won’t charge you a stock trading fee every time you make a purchase like with a ETF.
Personally I love ETFs. I think eventually they will overtake mutual funds to be the predominant investment vehicle of choice. BTW if you buy a ETF that pays dividends and you wanted to reinvest those dividends you would have to pay a trading fee each time. If your mutual fund charges you to buy or reinvest into more shares then I recommend switching to Vanguard.
Vanguard’s expenses are pretty low, incidentally, both for their mutual funds and ETFs. Their S&P 500 fund has an expense ratio of 0.05% if you meet certain minimums for example.
As noted earlier there are brokerage fees to consider with ETFs, as well as a bid-ask spread which can be thought of as a trading cost. On the plus side, you might be able to buy and ETF for slightly under its net asset value and sell it for slightly above it. On the down side, the opposite may occur.
As others imply, there’s relatively little difference between a very-low-fee open-end Fund like Vanguard and an ETF. But there is one minor difference which can be annoying with open-end funds. (I hope experts will correct me, if the following is wrong.)
If you sell an ETF at 11 AM on Wednesday, you get the price at 11 AM Wednesday. With an open-end fund, you’d get a price computed at Wednesday’s closing. If you prefer to manage your investments Wednesday evening when the market is closed, an order for an ETF will get Thursday’s opening price; an order for a mutual fund will get Thursday’s closing price. (OTOH, this pricing scheme can work to your benefit on overseas funds, IIRC.)
Similarly, if you sell an ETF Wednesday while the market is open, most brokers will let you use the cash proceeds to buy other shares the same day. If you sell an open-end mutual fund, you’ll need to wait a day.
To clarify, if you sell, say, an American overseas fund specializing in Asian shares after Asian markets close but before American markets close on Wednesday, you’ll get a price based on Wednesday’s closing Asian prices, while the best you could get with ordinary shares would be Thursday’s opening. This can be a big win if a big story will affect the next day’s prices.
(I’m sure there are serious obstacles to this today, especially since this “problem” was a major issue 15 years ago.)
Septimus is largely right about how the two investments work. ETFs can have lower costs, and can benefit a buy-and-hold strategy if used properly. Actively trading them can have real risks though, due to the possibility of leaning the wrong way.
One thing I’ll point out is that dividend reinvesting for mutual funds does not always incur a sales charge. That can provide a significant advantage when the amount is large.
I once read that, for a fund which gains, say 10% over a year, its typical holder will have gained only 8½% or such ! :smack: That’s because of the psychological tendency to play Buy High / Sell Low, and thus move in and out of the fund at just the wrong times. (An obviously bad strategy, yet which is the natural outcome of greed and fear emotions.) Since any buy or sell decision by an average investor is more likely than not to be a slightly bad decision, the antidote is simple: tend to Hold.
When choosing something to purchase, give preference to something you’d like to Hold.
(Warning: This investment advice is worth no more than you pay for it.)
If you make a market order, that is the case. If you make a limit order, you can set the maximum price that you would buy the ETF at. The order may not be placed. But you won’t have to worry so much about volatility which is often higher at the beginning of the day.
Some of the ETF markets can be pretty thin, so a market order can actually affect prices. Note also, that ETF prices can wander around even when they are tied to foreign markets where the exchanges are closed. Part of that might be “Price discovery”. But part of it might be simple variations in trading demand. You can evade some of this nonsense with an open end fund. Anyway check out the daily charts at google to observe ETF price behavior and note the discount and premium around the Net Asset Value (NAV).
There’s one more twist I didn’t get into. Readers here may have gathered that index funds typically have lower fees than actively managed funds (not always of course) and that ETFs tend to be index funds.
Almost all of Vanguard’s funds are indexes as well. But they have an additional advantage. Firstly, they are focused on lower costs, lower expense ratios. Secondly, they are organized as a cooperative: they don’t have outside investors. So their expense ratios tend to be lower than that of, say, iShares (which is owned by Blackrock, a for-profit company). There are exceptions: iShares and Fidelity use their SP500 fund as loss-leaders. And Schwab’s expense ratios are pretty competitive, IIRC. But the built-in advantage of Vanguard is worthy of note. As an aside, in my experience they also do not yank your chain: their customer service is very good (YMMV, etc).
TIAA-cref is also organized as a cooperative and has low expense ratios. But their menu of choices is also lower.
I agree with all of this. I’ve been a fan of Vanguard for a long time and I have a lot of respect for how they have organized their corporate structure. (The management company is owned by its own funds.)
Note that certain ETFs issue a schedule K rather than a 1099. This can be a major pain, as they ted to be sent later than 1099s, possibly even after April 15.
They mainly are commodity related ETFs. Some quick due diligence before buying the fund should tell you if this is the case.
All mutual funds pay dividends, so I assume by “dividend mutual fund” you just mean a mutual fund. Most mutual funds have a reinvestment service, under which (if you so choose) your dividends will be automatically reinvested in additional mutual fund shares.
ETFs do not have reinvestment services, but brokers often do. Whether the broker will charge you a commission for reinvesting ETF dividends, and if so what that charge will be, depends on your broker’s policies.
An ETF, like a mutual fund, holds its portfolio securities directly. If the value of those portfolio securities grows, then the ETF’s net asset value per share (NAV) increases (and vice versa, of course). The ETF broadcasts its updated NAV every few seconds throughout the trading day. Large financial institutions known as Authorized Participants monitor the ETF’s trading price and NAV. If there is too much divergence between these amounts, it creates an arbitrage opportunity for the Authorized Participant, because Authorized Participants, unlike you and me, have the right to purchase and redeem large block of shares, known as creation units, at NAV, in transactions directly with the ETF. These creation unit transactions are like regular mutual fund purchases and redemptions, except that the consideration is in kind, with the Authorized Participant contributing or receiving portfolio securities.
It’s true, there usually is not a lot of difference between an ETF and a similar index fund. If fees are important to you (and they should be), then look at the expense ratio of the mutual fund or ETF. The expense ratio is printed in the front of the prospectus and is also readily available online. For example, the SPDR S&P 500 ETF (often known by its ticker symbol SPY) has an expense ratio of 0.0945%. The comparable Vanguard S&P 500 Index Fund has an expense ratio of 0.17%. The difference is because the Vanguard fund must pay its own expenses of dealing with shareholders, while this expense is borne by the carrying brokers in the case of ETFs. If you qualify for Vanguard’s Admiral Shares, however (minimum investment: $10,000 for this fund), then the expense ratio is only 0.05%, which incidentally is also the expense ratio for the Vanguard S&P 500 ETF.
Note that these are all famously inexpensive. Most mutual funds, and even most ETFs, have higher expense ratios.
Septimus’s description of mutual fund and ETF pricing is accurate, except that mutual funds have worked hard to eliminate the ability to arbitrage overseas prices. As Septimus notes, if you sell an ETF Wednesday while the market is open, most brokers will let you use the cash proceeds to buy other shares the same day. Brokers may not be as willing for you to reinvest the proceeds of a mutual fund redemption on the same day, because the broker will not know the amount of the proceeds until after the market closes. However, if you hold your mutual fund shares directly through the fund company and want to buy shares of another fund in the same family, you can place a same-day order for an exchange.
Most ETFs are taxed as regulated investment companies, just like mutual funds, but it’s true that there are a few ETFs that are taxed as partnerships and issue Schedules K-1. There is a list of these at http://etfdb.com/2012/etf-tax-tutorial-complete-list-of-etfs-that-issue-a-k-1/, although it’s from 2012. None of them are conventional ETFs that invest in stocks and bonds.
These tend to be complex and expensive securities that are unsuitable for most investors. I would recommend that you avoid any of these, unless you have an investment adviser or are an investment professional yourself.