Just What Are Exchange Traded Funds?

By Sherrill St. Germain

Q: When you delivered our financial plan, one of your recommendations was to invest a portion of our portfolio in iShares S&P 500 Index Fund (AMEX: IVV.) I’ve been reluctant (basically nervous) about putting much money in (so far.) I think part of that reluctance is caused by not fully understanding the investment. IVV confuses me because it trades as a stock, but the descriptions I’ve found read like a fund. Would you give me a refresher on what IVV actually is and why you recommended it? I’m also willing to read more on it if you can point me in the direction of good information.

A: I'm glad you asked that! It's a great practice to make sure you truly understand an investment before diving in.

IVV is an “exchange-traded fund,” a.k.a. ETF. As you’ve read, it shares of the some characteristics as mutual funds, but in other ways, it’s like a stock. OK, what ways? Well, it’s like a mutual fund in that it is a “basket” of many individual securities, e.g. stocks. By buying 1 share of either a mutual fund or an ETF, you own a tiny piece of many different companies.

What’s different? When you buy or sell shares of a mutual fund, you transact business directly with the company that is managing it, Vanguard for example. They sell or redeem your shares to you directly. With an ETF, on the other hand, you are buying and selling on an exchange, like the New York Stock Exchange (hence the name “exchange-traded fund”), which you may recognize is why we say an ETF “trades like a stock.” Like a stock, you pay a commission when you purchase shares of an ETF. Like a mutual fund, there is an annual expense, but an ETF’s expense ratio is usually lower than that of a similar mutual fund. So unless you are making frequent purchases (like if you were buying 100 shares/month, i.e. dollar-cost-averaging) and racking up lots of commissions, ETFs typically cost less to own over time. That’s one reason I recommended an ETF instead of a mutual fund.

The other is that ETFs tend to be more tax-efficient than mutual funds. Since the money in question is targeted at retirement, but you’ve maxed out your retirement plan contributions, it’s probably going to sit in a “taxes-not-deferred” account for 15+ years. In that case, taking advantage of the increased tax efficiency of ETFs should add up in your favor over time. As you may have figured out by now, you could achieve a similar result by purchasing an index mutual fund with a similar investment objective. And if you’re still not entirely comfortable with ETFs, that might just be the best route for you.