Fortunately, a new breed of mutual fund appeared in the late 1980s that offers greater liquidity, lower costs and superior performance. Exchange-Traded Funds (ETFs) represent the next generation of mutual funds, and they can provide you with a more efficient return on your money once you learn what they are and how to use them.
Like traditional mutual funds, ETFs offer diversification and professional selection of securities or asset classes, such as stocks, bonds, real estate, commodities and precious metals. Many ETFs represent a foreign securities exchange. There are also ETFs that allow you to leverage the markets in either direction; that is, they will increase or decrease in value (possibly by several hundred percent) when the markets rise or fall.
Regardless of what they invest in, the tax rules for ETFs are much more straightforward than for their traditional counterparts. Mutual funds are often taxed when they are sold and are taxed based on their accumulated capital gains, which were generated in the fund and given to investors each year. But ETFs do not accumulate gains and losses within the fund in this manner, and investors will simply calculate gains and losses based upon their purchase and sale prices, making them much more tax efficient. ETFs are also much cheaper to buy and sell than traditional funds, which can assess hefty sales charges for purchases or redemptions.
Investing in ETFs
Getting started with ETFs is easy. First, you need to figure out what your investment objectives are. Are you looking for long-term growth, income or some combination of the two? Then you need to search for ETFs that fit your objective. There is at least one ETF available for every investment objective under the sun, so keep looking until you find exactly what you are searching for. Then you will need to open a brokerage account either online or with an investment firm in order to purchase them. ETFs are excellent investments if you want to time the markets because of their low transaction costs. But if you want your ETFs for the long term, then you may be faced with the temptation to sell them whenever they decline in price, which can disrupt your investment strategy and cause you to miss out when the market rebounds.
ETFs provide liquidity, transparency and diversification in a single tax-efficient vehicle with minimal expenses and low transaction costs. For more information on these unique instruments, consult your financial advisor.