What Are Advantage of ETFs Over Mutual Funds

Summary

Trading ETFs can diversify your portfolio, is allowed to trade the market in both directions, magnify profit by borrowing margin, expense ratios are pretty low. More technical indicators are available for ETF trading.

According to Investopedia, by trading an ETF, traders get the diversification of an index fund as well as the ability to sell short, buy shares on margin, and are allowed to purchase as little as one share. Another advantage is that the expense ratios for most ETFs are very low. There are over 1,000 different kinds of ETFs available. 

ETFs are used to track indices of broad-based US (Dow Jones, S&P, NASDAQ), international, country-specified (Japan, Australia, U.K. etc.), regional (Europe, Pacific Rim, emerging markets, etc.), industry (technology, energy, biotech, etc.), sector-specific (utilities, transportation, finance, etc.), bond, commodity, and market niches (REITs, gold, oil, etc.).

Studies have illustrated that asset allocation and diversification is a key factor responsible for investment returns, and ETFs are an excellent means for investors to build a portfolio that meets specific asset allocation needs. For example, an investor seeking an allocation of 75% stocks and 25% bonds can easily realize that portfolio with ETFs. That investor can even continue to diversify by dividing the stock portion into large-cap growth and small-cap value stocks, and the bond portion into bonds with different maturity dates.

ETFs are traded like stocks, in terms of real time span and continuous price changes during a trading day. You even can trade them at extended hours. ETFs possess characteristics similar to stocks. Thus, investors are allowed to trade on margin to magnify income, and sell short to hedge or protect your portfolio as well. Traditional mutual funds take orders during Wall Street Trading hours, but the transactions actually occur at the close of the market at 4:00 pm EST. The selling price is the sum of the closing day prices of all the stocks contained in the fund.  ETFs, by contrast, trade instantaneously all day long, and allow an investor to lock in a price for the underlying stocks or indexes immediately. 

When you trade ETFs, you only need to closely observe the macroeconomic environment, instead of each individual company’s PE ratio, management, profit margin, etc.  You do not need to do much fundamental analysis on individual companies. More technical indicators are available for ETFs trading. For example, VIX, ISEE, TRIN, and Smart Money Flow Index, etc., are tracking the general market only. They are not available for individual Stocks.

Most ETFs, especially index ETFs simply simulate underlying securities or indices. They are not subject to trading fees and commissions on a regular basis, incurred by fund managers who endeavor to beat the general market.  ETFs are cost-effective to own and hold over the long time period. This feature makes them specifically appealing to the typical buy-and-hold investors. ETFs charge extremely low annual fees, (as low as 0.04% of assets compared with 1.4% for average mutual fund fees (according to Morningstar). You could create a full and well-diversified portfolio utilizing ETFs only! Every investor loves to save management fees, especially those investors who place their savings into their portfolios. In helping investors save money, ETFs really compete very well with other securities. ETFs for underlying stock market indices charge even lower turn-over and management fees.

As you might know, the Vanguard 500 Index Fund is often known as one of the least expensive to maintain index funds. The Vanguard fund’s approximate 20 basis points of expense ratio are tremendously lower than the 100 plus basis points which are usually charged by other mutual funds.  However, if you compare the SPDR 500 ETF with the Vanguard 500 Index fund, the approximate 10 basis points expense ratio charged on SPDR 500 ETF are about 50% lower than the Vanguard 500 Index Fund. This puts other equity funds to shame!

As previously mentioned, like traditional stocks and bonds, ETFs can be traded intra-day plus during extended hours. This option facilitates risk-taking traders to trade along the near-term market movement through ETF trading. For example, if the stock market is experiencing a steep rise or decline during trading hours, it allows speculators to take advantage of volatility by purchasing an ETF that mirrors the index, and realize the gain before the market makes a turn.

Investing in a mutual fund that mirrors the S&P 500 does not provide this capacity. A mutual fund can’t allow speculative traders to profit from daily fluctuations, since each mutual fund can only be redeemed at the market close of each trading day and only has one price. Especially when catastrophic events occur in the market, the ETFs traders can escape from the financial disaster promptly.      

Be mindful that because ETFs trade through a brokerage firm, each trade incurs a commission charge. To avoid letting commissions shrink your profit margin, shop for a low-cost brokerage. ETFs also facilitate a buy-and-hold investor who is in a position to execute a large, one-time investment, and then wait for his equity to grow.

ETFs are favored by investors who like to reduce their tax burden. In terms of tax efficiency, ETF portfolios are even more preferred compared with index funds. Generally speaking, investors are provided more tax benefits especially when he trades large quantity of ETFs.  Selling ETFs is different from mutual fund redemption. It does not necessarily force fund managers to dump shares of underlying securities. Be aware that this process incurs capital gains and taxes. Therefore, the investor can defer taxes until the investment is actually sold. On the other hand, more frequent trading activity, and the different regulatory structure of mutual funds generate higher taxes as well. Moreover, an investor can opt for ETFs that don't have large capital gains distributions.

It is easy to comprehend the reason that ETFs have gained in popularity. Their associated costs are low, and the portfolios are flexible and tax efficient. The incentive for broadening the universe of ETFs comes, for the most part, from professional investors and active traders. Those investors with an eye for long-term gain will discover that the general market based ETFs will easily fit into their portfolios, when they have an opportunity for sporadic large-size purchases of equities.

Otherwise, investors interested in passive fund management, and who are making systematic investments with comparatively small amounts on a regular basis, are wise to stick with the traditional index mutual fund. Please keep in mind that ETF trading commissions might make it too costly for those people in the build-up phase of the investment process. 

If you wanted to maximize your profit, but are currently short of cash, you can borrow on margin to buy ETFs. The minimum share of ETFs you must buy is only one! The number of shares must be in whole numbers, not fractions or decimals. In this manner, ETF transactions are not like buying mutual funds. With funds, you can invest with a certain amount of money, and buy fractions of shares.  

If you wanted to short the market, you can buy Bear ETFs in lieu of shorting the stocks directly. You have more flexibility to trade in both directions in the general market, but mutual funds do not have this capacity. In addition, you are not required to pay marginal interest by buying Bear ETFs, but you do need to pay marginal interest if you sell short on securities.  Of course, you can short ETFs themselves as well.  Please bear in mind, selling short or buying Bear ETFs is a risky trading behavior. On the other hand, it can lead you to significant profits if you have compelling and sophisticated technical indicators to identify the market reversals and directions.

Do you feel frustrated if the general market is surging, but the individual stocks in your portfolio are underwater?  We know most investors and traders strived to beat the general market with their carefully accumulated portfolio. 

Why do some stocks with apparent great potential underperform? It is not hard to notice that some stocks do not follow the general market trend, such as Apple Inc. Once a red-hot stock, Apple Company’s total value could have been greater than a country’s wealth, at its apex! You never know when the tide will change for an individual stock, even when the general market is robust.  Apple stock reached its all-time high closing price on 9/19/2012 at $702. Actually, on 9/21/2012 it reached an all-time intraday high of $705.      

The Nasdaq-100 gained about 10% from September 2012 through June 2013, but Apple stock plunged about 40%. If you picked the wrong stock, you might be very frustrated and lose money in large quantities.

You might argue that the reason you trade individual stocks is that you might obtain a higher return rate. Again, we used AAPL as an example to compare its performance vs. TQQQ, during the time period between 11/25/2011 and 4/5/2012.  TQQQ, otherwise known as Nasdaq-100 Bull 3X ETF, looks for three times (3X) the daily investment result of the underlying security NASDAQ-100 Index without excluding fees and expenses.  As you can see, Apple stock had the best performance during 11/25/2011 through 4/5/2012.  It appreciated from $363 per share to $633 per share with an increase of 74%.  However, within the same time period, TQQQ which is a Nasdaq-100 Bull 3X ETF, grew at a 105% return rate.  If you choose the right ETF with acceptable risk level, you can still beat the individual stocks.