Use ETFs for small-term investments

A basic strategy for investing is to deposit a small portion of income in each payment period and deposit this money in securities that should grow over time. For a long time, index mutual funds have been a boon for investors who wish to make small investments on a regular basis.

However, exchange-traded funds (ETFs) are another way for investors to gain broad market exposure without having to choose specific stocks, and are usually a more cost-effective way of regular investment. Let’s take a look at the factors these investors should consider when choosing an index fund or an ETF.

Key points

  • For investors who want to save a little money every month or every salary, the Exchange Traded Fund (ETF) provides a cost-effective way to implement your strategy.
  • ETFs are very similar to index funds in many ways and are still suitable for investors who have relatively small regular investments.
  • Compared with index mutual funds, ETFs today tend to be cheaper, more liquid, and tax-efficient.

Compare the cost of ETFs and mutual funds

Both ETFs and index mutual funds provide investors with opportunities to invest in many areas of the global economy. With the large and increasing number of ETFs and index funds available, it is important to decide which sector or sectors have the most potential. After you decide which industry you want to invest in, you can narrow your search to a specific ETF or index fund.

Once you have identified several potential ETFs and index funds that meet your investment goals, the next step is to compare the costs of these funds. You must consider several cost factors; in most cases, ETFs lead in every situation.

Expense ratio

Funds usually charge clients based on a percentage of the total assets under management (AUM). Often referred to as the expense ratio, this expense covers the management expenses of the fund, such as the salary of the fund manager and all other operating and marketing expenses.

The expense ratio of ETFs tends to be lower because their operating costs are lower by design. Over time, although this cost difference is small, it can add up to a large amount due to the power of compounding.

tax

Your income will inevitably be taxed. Index funds, especially actively managed index funds, when they sell the company stocks they own to make a profit, taxable events occur to their investors, which happens every year. As the owner of the fund, you must pay capital gains tax on any reported income. ETF investors will not generate any capital gains before selling the fund shares. If the sale price is higher than the purchase price, they may have to pay taxes. This means that with ETFs, you can control when taxable events occur. Assuming that the value of the fund increases, index fund investors will also face capital gains tax when they sell the fund.

Minimum investment

Most index funds require their shareholders to open accounts with a minimum investment. For example, some Vanguard index mutual funds have a minimum investment of $3,000. Depending on the fund, the initial investment may be quite high. In addition, many funds require investors to maintain a minimum investment level to avoid being charged maintenance fees. ETF does not have any minimum investment scale.

The minimum fee that an investor must pay to purchase an ETF is the price of an ETF plus any commissions and fees.

Fees and commissions

The main disadvantage of ETFs is the cost of buying and selling stocks. Remember, you buy and sell ETFs just like stocks. Depending on the broker, the cost can vary greatly. If you invest $100 per month, you will also pay the broker monthly commissions and fees, which will hinder your return.

As long as you buy from a fund company, an index fund may not charge a fee to purchase its stock, even if the amount is small. Therefore, all of your $100 per month has been invested in this fund. However, the fund may charge an annual management fee to sell shares in the index fund. Other funds, especially those sold through brokers, may charge commissions called load.

Bid-ask spread

When buying or selling any stock or ETF, there is a spread between the buying price and the selling price, which is called the bid-ask spread. The larger the spread, the more investment must be made to overcome higher buying prices and lower selling prices. ETF spreads depend on liquidity and trading volume, just like any stock. Spreads for widely traded ETFs will be smaller, while those for less traded ETFs may have large spreads.

In addition, buying and selling prices will change throughout the day as the market changes. Just like buying stocks, this momentary change in buying and selling prices may be an opportunity to buy stocks at a lower price. Of course, if the ETF’s stock price drops, you may also buy it at a higher price that day. If you want to buy or sell ETFs, it is usually best to use limit orders to control the transaction price. On the other hand, index funds are priced at the close of the day, which is the price that investors will pay when they decide to buy.

Bottom line

When making small, regular investments, it is important to have a long-term perspective. First, determine the department you want to reach. Choosing the right sector can have a significant impact on the performance of your portfolio. The cost associated with your investment is the next important factor to evaluate.

The cost of an ETF is lower than that of an index fund, but the cost of buying and selling stocks may increase because every investor’s order for buying and selling will incur transaction costs. These costs will reduce the overall return on investment. In order to reduce these transaction costs, investors should consider using discount brokers that do not charge commissions, or may invest less frequently each year, and may invest on a quarterly rather than monthly basis.

As more and more brokers turn to zero-commission trading, ETFs have become a more attractive method of regular investment.

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