ETFs or Exchange Traded Funds were created for investors to enjoy the best features of both mutual funds and stocks. These are relatively modern investment instruments compared to mutual funds which are familiar to all through ages. So long, mutual funds have provided investors with manifold advantages like daily liquidity, broad diversification of portfolio, and professional management of funds. But ETFs have taken these traditional advantages several notches up, which account for their increasing popularity today.
When you know the etf stock definition, knowing about their advantages also will help you make an informed decision.
So, why do investors prefer ETFs?
There can be various reasons for this, but some of the most pertinent and vital ones are –
All managed funds involve operating costs regardless of their structure. These are generally administrative, custody, distribution, marketing, and portfolio management costs. ETFs generally involve lower costs compared to mutual funds, and these expenses can also be streamlined significantly.
Lower costs of ETFs are mainly because the fund administrative expenses for client-service are shifted on to brokerage firms holding their customer accounts and securities. Besides, expenses involved are also lower for monthly notifications, statements, and transfers. In case of mutual funds, investors must be supplied with monthly and annual statements and reports of the funds’ performances and other important details. But that is not the case with ETF companies, which automatically reduce their overheads. Most importantly, the nonexistence of mutual funds redemption charges further reduces the involved expenditure of ETFs.
Owing to their structural differences, mutual funds investors typically incur higher taxes on capital gains than ETF investors. And the capital gains tax is carried on throughout the entire tenure of mutual funds investment. But for ETFs, capital gains tax is payable only at the time of sale of that ETF. So this is one major tax benefit provided by ETFs that mutual funds cannot offer.
ETFs issue two types of dividends – unqualified and qualified dividends. For the dividend to be qualified, the investor has to hold the ETF for at least 60 days before the payout date for the dividend. The rate of capital gains tax for qualified dividends is usually in the 5 to 15% range and depends on the income tax rate of the investor. In the case of unqualified dividends, the tax rate is the same as the income tax rate of the investor.
Open-end mutual funds can only be traded once per day after the regular market session is over, and all trading activities are carried out with the company issuing mutual funds. While trading once in a day works for the majority of long-term investors, it becomes a limitation to many others who seek greater flexibility. ETFs offer that flexibility to investors.
You can buy or sell ETFs on the same day when the stock market is open and transactions are almost instantaneous. The price of ETFs is also consistent during the regular exchange hours. As an investor, you will know immediately how much you have paid or gained from buying or selling ETFs. This is an added advantage if you want to engage in intraday trading since it makes fund management smooth. Plus, the flexibility in trade orders is hugely beneficial in making timely investment decisions. And you can reorganize your investment portfolio between particular asset classes like bonds, commodities, or stocks. This level of flexibility is not possible with mutual funds investment.
Diversifying portfolio and managing risks
ETFs offer that quick exposure to a wide range of market segments that investors often want for diversifying their investment portfolio. Nowadays, ETFs are available across all main asset classes, currencies, and commodities which makes it easier for investors with different investment plans and outlooks. With ETFs, you can purchase or sell stock market based on its volatility, or invest continuously in global currencies with the best returns. Also, if there is a potential risk in a specific sector, you can short trade your ETFs in that sector, to minimize your risk. You can also purchase an ETF that shorts that sector for you.
Given these solid benefits, if you want to make a cost-effective investment that is also safe and flexible, nothing can beat ETFs.