The ABC’s of ETF’s

Wednesday, December 15, 2010

This holiday season, would there be anything better than going to the mall to buy a present, only to see it on sale at a huge discount? In the financial world, the equivalent would be to avoid paying huge commissions or expenses on investments when you don’t need to. Exchange Traded Funds (ETFs) can be that special investment that warms the cockles of your heart this winter, but here are a few things about them that you should know going in:

Trade like stocks – ETFs behave like index funds but trade throughout the day like a stock. This allows for mutual fund like diversification and stock like flexibility. It also means you don’t have to wait until the end of the day to liquidate the holding like you would in a mutual fund.

Low expense – Many buying mutual funds in their investment accounts and retirement plans are paying an up-front commissions or a deferred sales charge. ETFs combine the diversity of a no-load index mutual fund and the expense of an online trade. For the conscientious shopper, it provides the best of both worlds.

Available in retirement plans – Business owners are always looking for ways to reduce expense, and the use of ETFs in a 401k might be advisable. There should be extreme due diligence in the investment selection and employee education.

You don’t always have to use an ETF - With the explosion of ETF popularity, there is now a fund for pretty much every type of investment objective. However, as with any investment, you need to make sure it establishes a track record. The largest ETFs have shown that they can consistently provide comparable returns for 3 years or more. Eventually, there will be a shake out in the ETF world, just as there has been in the mutual fund world. Poor performance and lack of assets will wipe out the most obscure of the funds that have come out.

You can have a mixture of ETFs and Mutual Funds – There’s nothing that says you can’t mix investment types. If you’re simply trying to mirror the S&P 500, an ETF provides an inexpensive way to do that. However, if you want exposure to the emerging markets, a no-load mutual fund with a proven track record may be the way to go.

Dan Forbes is a regular contributor on business financial issues. He leads the firm Forbes Financial Planning and can be reached at [email protected]