ETFs: Index Funds Disguised as Stocks

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In the investment world, what looks like a mutual fund, often tracks major indices, yet trades like a stock? If you guessed an exchange-traded fund or ETF – congratulations! You’re an investment whiz! If not, we'll explain more below.

It's important to understand that 403(b) plans do not generally offer ETFs, and 457 plans may or may not. But you may be interested in exploring ETFs outside your 403(b) or 457 plan.

How It Works

Behaving like a stock: An ETF represents an investment fund that trades on the stock exchange – very similar to how individual stocks trade. For example, an ETF can be bought and sold throughout the day through a broker-dealer.

Looking like a mutual fund: Its holdings include different groups of assets bundled together such as stocks (equities), specific commodities (crude oil, precious metals) or bonds (fixed-income investments). This is similar to many traditional mutual funds that also offer a package of investments.

Offering traits of an index fund: Many ETFs are structured to follow a major index such as the S&P 500 or MSCI EAFE (Morgan Stanley Capital International Europe, Australasia, and Far East Index). This type of ETF is not actively managed by a fund manager.

What makes an ETF unique? An ETF differs from an index mutual fund because it does not sell or redeem individual shares at net asset value (NAV). Instead, ETF shares are bought and redeemed in large blocks (25,000 to 200,000 shares) by financial institutions. These blocks are called creation units. The price of individual shares will fluctuate above or below NAV depending on investor demand for them.

Advantages of an ETF

Many investors choose ETF shares because of their broad asset-allocation makeup. It fits a long-term investment strategy like a glove. Additional advantages include:

Lower costs. Most ETFs are not actively managed, which means they do not have the costs associated with selecting assets. They also benefit from lower marketing, distribution and accounting expenses. However, it is important to note that ETFs are not necessarily cheaper than index mutual funds. Larger investments may be able to access share classes that carry lower internal management fees than ETFs. Be sure to explore all of the fees in any investment you are considering.

Greater trading flexibility. ETFs can be bought and sold throughout the day as opposed to mutual funds, which are limited to end-of-the-trading-day transactions. However, ETFs with low liquidity (meaning they are not widely traded) may cost more to trade. Since they are bought and sold like stocks, they may have a high "spread" between the bid price (the price someone is willing to pay) and the ask price (the price a seller is willing to offer). You may want to check the average daily volume of shares traded and select an ETF with a high trading volume.

ETF shares can also be traded by using stop and limit orders. These trading tools allow investors to predetermine their own buy/sell comfort thresholds.

Tax efficiency. Because there is low turnover of the securities in an ETF, capital gains are generally low, too. In addition, securities in the ETF do not have to be sold to meet investor redemptions like they would in a mutual fund.

Diversification.* Because many ETFs are structured to track a major index, they offer built-in diversification across that index. They also offer exposure to a wide variety of markets, including international investments, different industry sectors, bonds and commodities. However, be aware that some ETFs track a narrow market segment and may not be particularly diversified.

For Help with Your Portfolio Strategy

When devising an investment strategy to meet your needs, it’s important to consider your financial goals, time horizon and tolerance for risk. If you're investing outside your 403(b) or 457 plan, consider whether an ETF will complement your portfolio.

* Diversification cannot guarantee a profit or protect against loss in a declining market.