NEW YORK (MainStreet) — The rise in the popularity of exchange-traded funds (ETFs) is occurring, because investors are drawn to their lower fees, liquidity and ease of diversification.
Although ETFs have been around since 1993, their attractiveness has soared in the past few years as more 401(k) and IRA plans are offering them as an option. A decade ago, the total amount of funds in ETFs totaled $200 billion and investors could only chose from a few dozen options, said Wayne Connors, a managing partner of Retirement Investor, a Glastonbury, Conn. company where investors build their own IRA portfolios.
ETFs are an “advantageous way” to invest for retirement, he says, since the fees are much lower than traditional mutual funds and trade like a stock by tracking an index, such as a commodity or a group of assets. Assets in ETFs now exceed $2.0 trillion, and there are over 1,600 ETFs for investors to choose from.
One advantage of ETFs is that you buy a number of shares on an exchange and receive an intra-day market price, which takes place at the moment you place your order, said Jim Rowley, a senior investment analyst in the Vanguard Investment Strategy Group in a blog post. Mutual funds don’t give investors this option and the price you pay for is the net asset value at the end of the day.
Here are some tips on how to purchase them as a way to diversify your portfolio.
Purchasing ETFs Can Take Place Any Time Market Is Open
You can purchase ETFs anytime during the stock market is open, and since they trade on major stock exchanges, their prices will also fluctuate just like a stock. Think of ETFs as “basically a better form of a mutual fund since they are more liquid and tax efficient,” said Sara Rajo-Miller, a wealth manager of Miracle Mile Advisors, a Los Angeles-based investment firm.
Most mutual funds also have a minimum investment amount of $3,000, whereas you can buy as little as one share of an ETF.
Avoid Trading Them Too Often
Investors should view ETFs like mutual funds and avoid trading them too often. “We use ETFs to build diversified portfolios and often hold them over extended periods of time rather than day trading them,” Rajo-Miller said.
While some companies allow you to trade them for free, others charge a fee, which can easily add up over time.
“Just because you can trade ETFs frequently, doesn’t mean you must trade them frequently,” Rowley said. “ETFs can be used to build low-cost, broadly diversified portfolios—even for strategic, long-term investors.”
Know the Fair Value of the ETF
When you are ready to purchase an ETF, you will see the bid price and an ask price. The bid price is the highest price a potential buyer is willing to pay for the ETF or any security. The ask price is the lowest price a potential seller is willing to agree to or what you could buy it for.
One way to gauge the value of the ETF is to look at the difference between the bid price and ask price, which is known as the bid/ask spread. This can be found on Google or Yahoo Finance, said Matthew Tuttle, CEO of Tuttle Tactical Management in Stamford, Conn.
“If the spread is pretty tight, or no more than $0.06 or so, you can put a limit to sell at the bid or to buy at the ask,” he said. “If the spread is wide, then you would place your order in between. If you have a large order, you want to call your brokerage firm's block trading desk and they can walk you through it.”
When To Purchase or Trade an ETF
Try to avoid trading during the first and last 15 minutes of the trading day, Tuttle recommends. “During the open, it takes market makers a bit to figure out the prices of all the underlying securities in an ETF, so during that time the bid/ask spreads are likely to be wider,” he said. “At the end of the day you can see a lot of order imbalances that can also impact spreads.”
Markets orders are ones that occur if you purchase shares of an ETF when the market is open.
“The prices of ETFs fluctuate, so there is never an exact right price to buy them and it all depends on their valuation metrics,” said Rajo-Miller said.
As soon as you place an order, you will likely receive the current price. It can be tricky if the market is having a volatile day.
“Market orders put you at the mercy of the market and you are better off placing limit orders,” Tuttle said.
A limit order means the purchase of the shares of the ETF only occur if the price of the ETF drops to the one you are seeking. If your limit order is $92 and it trades for $94 that day, then your order will not have executed. If you are unsure of what price to seek, ask your financial advisor.
Limit orders can be an effective way for investors to protect themselves from sudden, drastic price movements that can occur in the market. "Prices can swing very suddenly and sharply momentarily," Connors said.
Buying shares of an ETF at the current market price, known as the ask price is the best option for long-term investors. If you wait for the price to drop a few dollars, the purchase may never get executed.
"ETFs should be viewed as an easy way to buy an index fund," he said. "If you buy one share of an ETF, you're owing thousands of companies."
Some financial advisors recommend that investors shy away from them. Limit orders may be appropriate for certain types of ETFs, but "we generally do not use them," said Rajo-Miller said.
--Written by Ellen Chang for MainStreet