ETFs are baskets of stocks in a variety of broad market, sector or capitalization categories, similar to mutual funds.
Some of the reasons why most consider ETFs superior to Mutual Funds:
- More cost-effective because of lower operating and transaction costs.
- More liquid and flexible than funds; they can be traded anytime during the market day like stocks.
- More tax-efficient because they typically have very low distribution rates.
- Often have better performance than index funds because they are more efficient.
- Offer investors a more liquid and efficient way to access hot overseas markets like Brazil, Russia, India and China, in part because they can be traded throughout the day, helping to ensure that the investment can be disposed of mid-day, instead of at the day's end pricing.
The below article from Forbes gives a great overview of points to consider:
The Smart Trader's Guide to ETFs
05.09.11, 6:00 PM ET
Exchange-traded funds are one glorious success story, having gone from nothing to $1 trillion in assets in 18 years. The best of them beat the classic Vanguard mutual funds in the cost game.
But you have to know what you're doing. If you are sloppy with selection or execution you will fritter away the ETF cost advantage. Here are three rules for cost-conscious ETF investors.
Compare expenses. Consider the two big emerging-market funds, from Vanguard and iShares. "Emerging," by the way, is shorthand for "where property laws are sketchy." These funds invest in China, Russia and Brazil. Between them they sit on $90 billion. In Vanguard's case the ETF is attached to an old-fashioned mutual fund with the same portfolio.
Vanguard and iShares have slightly different collections of stocks, so one might do a point or two better than the other in any year. But that, to me, is an inconsequential fact for two reasons. There's no way to predict the outcome, and, in any event, these performance differences tend to even out over time.
The more important difference is in the expense ratios. Vanguard peels off 22 basis points for its portfolio work. That's $22 a year on a $10,000 investment. BlackRock's iShares wants 69 basis points. Over 30 years that difference of half a percentage point compounds to 13%.
If your $10,000 earns 9% a year before expenses, the tiny cost difference will balloon into a difference of $16,000 in your pocket in 2041. Alongside this, the free pass your broker did or didn't give you on the $9 trading commission doesn't really matter.
Never buy an expensive fund unless there is compelling evidence that it is likely to outperform the cheap alternative. In this match, Vanguard MSCI Emerging Markets (VWO, 49) is the winner.
Be careful with market orders. A market order gets executed at whatever price is needed to complete the deal. In hyperactive stocks like the ETFs that State Street has for the S&P 500 and gold, market orders do no harm. You can get several thousand shares without disturbing the price.
But if you have a hankering for the FaithShares Baptist Values fund, which moves 200 shares on a busy day, a market order for 2,000 shares is a bad idea. It's an invitation for the marketmaker on the other side of the trade to reach into your pocketbook and help himself.
If you are interested in an ETF whose volume is less than a million shares a day, put in a limit order. You offer to pay, let us say, $30 a share and not a penny more.
Gary Gastineau, author of a textbook on ETFs, recommends a "marketable limit order." If a stock is quoted at $29.95 bid, $30 ask, and you really want it, your limit order for 2,000 would be at the ask price.
You might or might not tease out all the shares you are looking for. You might get 800 and have to return the next day for more. But that is better than putting in a market order that gives you 200 shares at $30 and the other 1,800 at $31.
Don't let orders sit around. When you put in a buy at 10 a.m. and then walk away from your desk, you become a patsy for professional traders. In effect, you are giving these guys a free put option, says Gastineau. He knows all about this. His first textbook was on option theory.
Say that an ETF is quoted at $29.95 bid, $30.05 ask. You bid for 2,000 at $30, beating the previous bid by a nickel. Your position at the head of the buying line may not last for long. A sharpie with a split-second computer can elbow you aside with a bid at $30.001. He grabs the first 2,000 shares that come along.
If this is a stock that jumps around a lot, it could end the day at $29 or at $31. If it goes up, the high-frequency trader pockets a $1,998 gain. If it crashes, he unloads his position on you. He's out $2, and you're out $2,000.
Solution: If you are interested in a thinly traded stock, put in your bid, then yank it an hour later if a buttinsky quote pops up on your screen. Wait at least a day before returning.
If you don't want to spend your afternoons trying to outsmart marketmakers, stick to heavily traded ETFs with low expense ratios.
For big-company stocks SPDR S&P 500 (SPY, 132) is the obvious choice. Its annual fee is nine basis points. For a broader mix, with 3,400 stocks, buy Vanguard Total Stock Market (VTI, 68), at seven basis points. Another option is the Schwab U.S. Broad Market ETF (SCHB, 31), which owns 1,500 stocks and will cost you six basis points.