Investing in your retirement
ETFs, which track the performance
of a stock or bond index, are much like index
funds but with a bit more bling.
Offering broad market exposure, tax efficiency and lower operating costs, they are designed to pick up where mutual funds leave off.
"One of the chief benefits of the ETF is that they tend to be significantly cheaper than conventional mutual funds," says Sonya Morris, editor of Morningstar ETFInvestor, though some index funds offer competitive expense ratios, she adds.
ETFs are baskets of securities bought and sold on an exchange, not unlike individual securities.
Among the more popular ETFs
are Spiders (SPY), so named because they track
the Standard and Poor's 500 index of large-cap
stocks. Diamonds (DIA), meanwhile, track the
Dow Jones industrial average, while Cubes
(QQQQ) follow the stocks held in the Nasdaq
ETF prices fluctuate real-time throughout the day, making them well-suited for individual investors engaged in intraday trading.
They also can be bought on margin
-- using borrowed money -- and sold short
for those betting on a market slide.
Another plus of ETFs is that,
because they don't have to sell underlying
securities to meet redemptions, they rarely
distribute taxable gains to shareholders.
ETF investors sell shares to other investors.
Anytime you trade an ETF, notes Morris, you
pay a brokerage commission, making ETFs less
attractive for active traders and anyone using
a dollar-cost-average investment strategy
(those who buy into a position with small,
periodic investments over time).
At the same time, the flexibility
to trade ETFs like stocks can become a pitfall
for some investors. "Unfortunately, that encourages
investors' worst instincts -- to chase past
performance," Morris says.
Despite their growing popularity,
ETFs remain largely unavailable to investors
through 401(k)s and other employer-sponsored
retirement plans, which often restrict their
offerings to mutual funds.
However, those considering new
investments for their personal portfolio should
weigh the pros and cons of ETFs and mutual
funds against their need for tax efficiency
|Characteristics of index funds and exchange-traded funds
||Index mutual funds
|Generates taxable distributions beyond investors' control
|Offers broad diversification
|Low expense ratio
|Triggers brokerage commissions
|Allows intraday trading
|Can be bought on margin or sold short
|Appropriate for dollar-cost averaging
|Allows reinvestment of distributions