Hi and welcome back to this episode of The Winning Investor’s Quick and Dirty Tips for Beating the Market!  I'm your host, Andrew Horowitz and in this episode, I will be introducing you to the basics of ETFs, or exchange-traded funds.  These funds are similar to mutual funds but offer some advantages that mutual funds can't match, so they can be a great addition to a diversified winning investor's portfolio.

What are ETFs and Mutual Funds?

By definition, an exchange-traded fund is a tradeable basket of stocks that offers instant diversification depending on the type or style of the fund. But first, let's compare mutual funds to exchange-traded funds.

A mutual fund is a group of investments—like stocks and bonds--managed by a single manager or group of managers whose goal is to beat their benchmark index, as an example may be the S&P 500. They do this by selecting only the stocks they believe will perform better than the market. This is called active management.

An exchange-traded fund is a passively managed basket of stocks and is designed to track their benchmark index as closely as possible. By definition, we would not expect an ETF to outperform its benchmark. But research shows that many mutual funds do not outperform their benchmarks either after fees and expenses are considered; so it's not necessarily a bad thing that an ETF will just closely track an index. The name of the game is profits!

How do ETFs Differ From Mutual Funds?

Because mutual funds are managed by individuals or teams, they often have higher expense ratios, which means that you will be paying anywhere from 1, 2 or 3% of your investment each year to the management team.  However, since ETFs are passively managed, you will pay much less of a management fee, which could be anywhere from 0.3 percent to 0.7 percent. This fee is almost always less than one percentage point of your investment.

Also, when you want to invest in a mutual fund, you will often have to call a broker or purchase funds from a particular company if you want to invest in their particular fund.  Also, you can only buy or sell a mutual fund at the end of each business day, which gives you less flexibility.

In contrast, you can buy or sell an exchange-traded fund at any time of the day and you don't have to go through a broker if you have a personal online trading account through any of the low-cost brokers, such as Schwab, Ameritrade, E-Trade, Scott-Trade, and many others.  You'll still have to pay a commission, but the commission will most likely be much less than if you went through a broker to invest in a standard mutual fund.

What are the Benefits of ETFs?

I will discuss some of the different types of ETFs in the next episode, but in summary, here are the main reasons why you should consider investing in an ETF instead of a standard mutual fund:

  • ETFs are more liquid than mutual funds, in that you can buy or sell them at any point in the day. 
  • It is generally easier to invest in an ETF than a mutual fund, and often you will pay much less in commissions to do so.
  • You are not required to purchase an ETF through a broker or money manager, as you are with certain mutual funds.
  • You will also pay a lower management fee for holding an ETF, which can be as great as a one percent difference in savings each year.
  • ETFs will closely match the performance of an underlying index like the S&P 500 or Dow Jones Index, whereas it's quite possible that a similar mutual fund may underperform the same index.

Now that we've learned some of the basic comparisions between mutual funds and exchange-traded funds, we’ll dig a little deeper and see what else an ETF can do for us to help us diversify our portfolios in an upcoming episode!

If you have questions, please feel free to email me at winninginvestor@quickanddirtytips.com.

Keep with us as we discuss even more ways to become a winning investor in our next podcast! If there’s a question you’d really like to ask, just email me at winninginvestor@quickanddirtytips.com. Until next time, this is Andrew Horowitz with The Winning Investor’s Quick and Dirty Tips for Beating the Market wishing you all the best on your quest to investment success. or call 206-338-0836. That’s 206-338-0836 and maybe your question will appear on the show. And if you like the show, tell a friend or leave a review on iTunes.