Intuitively, you might think of conventional stocks as the better option to choose over Exchange-Traded Funds (ETFs). With ETFs, you have to pay commission fees every time you make a trade, right? But in reality, that’s not always the case! Here are some of the ways ETFs can come out ahead of conventional stocks.
Introduction
An exchange-traded fund, or ETF, is a type of investment that can be bought and sold like a stock. ETFs are composed of a basket of assets, such as stocks, bonds, or commodities. They offer investors the ability to diversify their portfolios without having to purchase each asset individually. ETFs also provide exposure to a wide range of investments and can be used to gain access to hard-to-reach markets. One of the major benefits of ETFs is that they are highly liquid, meaning they can be bought and sold quickly and easily.
What Are ETFs?
An ETF is a type of investment fund that holds a basket of assets, such as stocks, commodities, or bonds, and trades on an exchange. ETFs are similar to mutual funds in that they offer diversification and professional management, but they differ in several key ways. For example, ETFs are more flexible and innovative than traditional mutual funds, and they often have lower fees.
Although both mutual funds and ETFs are types of investment funds, they differ in several ways. For example, ETFs trade on an exchange just like a common stock does, which means investors can buy or sell shares throughout the day. In contrast, mutual fund shares are bought and sold at a single price that’s set at the end of each trading day. Mutual funds also have more restrictions on how many shares can be bought or sold during a single trading day. Another difference is that ETFs typically have lower annual expenses than similar mutual funds do. Mutual fund fees may include management fees and ongoing transaction costs, while ETFs tend to charge much smaller annual fees for trades in and out of positions as well as management expenses.
Exchange-traded funds and conventional stocks differ in a number of ways
Most notably, ETFs are traded throughout the day on a stock exchange, while conventional stocks can only be bought or sold during market hours. ETFs also tend to be more diversified than conventional stocks, and they’re often cheaper, too. But one of the biggest advantages of ETFs is that they’re constantly innovating. For example, there are now ETFs that track everything from the movements of the U.S. dollar to the price of gold.
Still, it’s not unusual for investors to invest in both conventional stocks and ETFs. This is because there are a number of situations in which an ETF may be a better investment than a conventional stock, even though they’re technically different. Perhaps most notably, many experts believe that ETFs are more tax efficient than conventional stocks. It’s important to understand how taxes work on your investments so you can determine if an ETF or a traditional stock is right for you.
ETFs contain different types of securities than conventional stocks
One of the benefits of investing in an ETF is that you get exposure to a wider range of securities than you would with a conventional stock. For example, an ETF might include stocks from different sectors, such as healthcare, technology, and finance. This diversification can help reduce risk because it’s unlikely that all sectors will perform poorly at the same time. Another benefit of ETFs is that they’re often more tax-efficient than stocks. This is because ETFs are structured in a way that minimizes capital gains taxes.
ETFs typically track an index. Many indexes are weighted according to market capitalization, which refers to a company’s total value. If a company is valued at $100 million and has 1% of a particular index, it will be worth 1% of that index’s overall market capitalization. This system makes sense because larger companies tend to have more influence on an industry than smaller ones do. For example, Facebook (FB) accounts for 13% of online advertising revenue in 2016, according to Statista figures. Alphabet (GOOGL), by comparison, accounted for 9%. The weighting formula varies by index provider and region, however. In many Asian countries, for example, there is no limit on how much any one company can contribute to an index.
ETFs offer greater diversification than conventional stocks
When you purchase an ETF, you are buying a basket of stocks or other securities that track an index. This offers greater diversification than purchasing a single stock, as you are spread across multiple companies and sectors. This can help to reduce risk, as you are not as reliant on the performance of any one company. Additionally, ETFs often have lower fees than mutual funds, making them a more cost-effective option.
Some ETFs, such as inverse ETFs and leveraged funds, can be more risky than others: Certain ETFs offer a degree of leverage or are designed to go up when an index goes down. While these products can help you take advantage of trends in your favor, they can also increase losses if you get your timing wrong. Before buying into any kind of ETF, do your research and understand how these types work so that you know how much risk you are willing to accept. You may also want to speak with a financial advisor about what kinds of risks are appropriate for your portfolio.
ETFs provide low investment costs
ETFs are low-cost investment vehicles that offer many benefits over conventional stocks. For example, ETFs typically have lower expense ratios than mutual funds, making them a more cost-effective option for long-term investors. In addition, ETFs offer greater flexibility when it comes to investing strategies. For instance, investors can use ETFs to gain exposure to a specific sector or market without having to purchase individual stocks.
In addition, investors can trade ETFs in any market, including an investor’s local market. These benefits can come in handy when you’re trying to reach your investment goals. For example, you may want to move a large amount of money out of stocks and into bonds but lack sufficient time to sell your stocks at optimal times for capital gains purposes. In situations like these, investors can sell their stock and purchase an ETF that tracks a given bond index instead. This allows them to hold their investments while still meeting their investment goals.
Leveraged and inverse ETFs use derivatives to enhance returns, which can lead to losses as well as gains
While conventional stocks give you a share of ownership in a company, ETFs provide exposure to an entire index or sector. This can be beneficial if you’re looking to diversify your portfolio. ETFs are also more tax efficient than mutual funds, since they don’t generate capital gains when they’re sold. And because ETFs trade on an exchange, you have the flexibility to buy and sell them throughout the day.
In addition to traditional ETFs, there are leveraged and inverse ETFs. These funds use derivatives to enhance returns, which can lead to losses as well as gains. You’ll want to be careful using these funds since they have been known to have serious side effects if you don’t fully understand how they work and aren’t used properly. Always consider consulting a financial advisor before investing in them.
ETFs have lower capital gains taxes than conventional stocks
Conventional stocks are taxed at the higher long-term capital gains rate if held for more than a year, while ETFs are taxed at the lower short-term capital gains rate if held for less than a year. In addition, ETFs offer tax benefits in other ways. For example, when an investor redeems shares of an ETF, only the gains on those shares are taxed, whereas with a mutual fund, the investor is taxed on the entire redemption.
ETFs can also help individuals defer capital gains taxes. When an investor uses capital losses to offset taxable gains in a conventional stock portfolio, only 50 percent of those losses can be used in any given year. However, since an ETF’s value is not tied to a single stock, investors can use capital losses from an ETF to offset taxable gains on other investments within their portfolios, thereby reducing or eliminating some tax liability altogether. For example, if one sold shares worth $10,000 for $5,000 and had no other sales for that year (thus having a net loss), up to $3,000 could be applied against other taxes that year.