The growth of ETFs (exchange-traded funds) over the past several years has been nothing short of explosive. They offer a fresh alternative to individual stocks and bonds by combining the well-known benefits of indexing (diversification, tax efficiency, and lower costs) with real-time pricing and lower investment minimums.
See which could have a place in your portfolio
In the first of our 4-part series exploring different types of ETFs, we looked athow bond ETFs might fit into your portfolio. Later this year, well dive into international stock and bond ETFs, as well as ESG (environmental, social, governance) ETFs.
A stock ETF typically comes prepackaged with hundreds or thousands of individualstocks, providing instant diversification. If 1 stock price falls, the others are there to help pick up the slack, helping reduce your risk of losing money. On the other hand, when you own 1 or a few stocks directly, if a specific stock price falls, your account balance takes a bigger hit.
Most ETFs are index funds. They dont investdirectlyin an indexlike the S&P 500because the index is only arepresentationof a certain market segment.
With so many stocks in a single ETF, whos overseeing them? Thats where a professional fund manager comes ininvesting directly in the stocks the index tracks (or a representative sample). It looks a little like this:
Sometimes an index changes the stocks it tracks or the weighting of each stock. When that happens, the manager is responsible for mirroring those changes to make sure the ETFs returns dont stray from its index.
A single, all-inclusive stock ETF offers the most efficient way to invest in nearly every aspect of the U.S. and international stock markets. If youre looking for a more focused investment, you might consider ETFs that concentrate on specific characteristics, such as:
Market capitalization.This refers to the size of a company as measured by the total value of its stock shares. Companies are then categorized based on their capitalization. Large-cap companies tend to be more stable than small-cap companies, but smaller companies may have more growth potential.
Style.Growthstocks represent expanding companies that reinvest the money they make into their businesses, which ideally results in an increasing stock price. (Examples: Amazon, Apple, Netflix.)Valuestocks represent established companies whose price may be undervalued by the market. (Examples: AT&T, Verizon, Coca-Cola.) When you see stock ETFs identified as blend, theyre investing in a mix of growth and value stocks.
Geography.Some stock ETFs invest in companies based on their locationU.S. only, non-U.S. only, or a combination. Others focus on companies from developing or emerging markets or from particular countries or regions. The narrower the focus, the greater the potential risk. But that narrow focus also gives you the opportunity to precisely control whats in your portfolio.
Sector.Sector ETFs focus on one industry, such as energy, technology, or health careand with that concentration comes potentially more risk.
As mentioned earlier, perhaps the greatest difference is the instant diversification an ETF provides. Theyre also more convenient for you to own because the fund manager oversees the stocks in the ETF, so you dont have to research every stock yourself.
They cost less too. When you buy or sell 1 ETF, you pay 1 commission no matter how many stocks are in the ETF. But if you buy or sell stocks individually, you pay a commissionevery time you buy or sell shares.
As an added bonus, every Vanguard ETF®is available commission-free through a Vanguard Brokerage Account. (Commission-free trading of Vanguard ETFs®applies to trades placed both online and by phone.Learn more about other conditions & costs that may apply.)
Individual stocks have a slight advantage over ETFs when it comes to capital gains. No matter which you own, when you sell shares for more than you paid, you may have to pay taxes on the capital gains. But it ends there for individual stocks.
With a stock ETF, the manager could be buying or selling individual stockswithin the ETFand experiencing gains. At the end of the year, if gains exceed losses, law requires thosegains to be paid outto ETF shareholders, and those gains could be taxableeven if you didnt sell any of your shares. Its rare, but it happens.
The good news is that 86% of all Vanguard ETFs havent had a taxable capital gains distribution in the past 5 years.* And you can ignore all of this if you hold ETFs in a traditional, Roth, or SEP-IRA because their earnings grow tax-deferred.
Theres not much difference between individual stocks and stock ETFs. While individual stocks may send you dividends directly, stock ETFs gather all the dividends from their underlying stocks, divide them proportionally among all of its investors, and distribute them all at onceusually quarterly.
You can then decide whether you want to accept your dividends as income orreinvest themback into the ETF.
Vanguard ETFs and Vanguard index mutual fundsshare many of the same characteristicswhen youre comparing similar funds. For example, the performance, risk, and tax efficiency ofVanguard S&P 500 ETF (VOO)andVanguard 500 Index Fund Admiral™ Shares (VFIAX)are exactly the same because theyre simply different share classes of the same portfolio.
Their trading costs are the same at Vanguard toothat is, zero. Theres no commission to buy or sell any Vanguard ETF in a Vanguard account. Similarly, there are no transaction fees** for any Vanguard mutual funds.
You can buy any Vanguard ETF for the price of 1 share (as low as $50). Meanwhile, the minimum investment for most Vanguard mutual funds is $3,000. ETFs lower minimums could be ideal for newer investors looking for a lower threshold or for experienced investors who want to get into specific areas of the market with less money.
ETFs and mutual funds are also priced differently. Mutual funds have 1 pricethe net asset value (NAV). Its only calculated once a day,afterthe markets close. Regardless of what time you place your trade, you and everyone else who places a trade on the same day receives the same price, whether youre buying or selling shares.
ETFs have NAVs too, but they also have market prices (among other prices) that change throughout the day in real time. That means the price you pay or receive can change based on exactly when you place your order, and youll know that price when buying or selling shares.
Vanguard mutual funds let you set up automatic investments, exchanges, and withdrawals. And if youre 70½ and need to take required minimum distributions (RMDs) from your IRA, you can take them directly from a mutual fund. You dont have those options with ETFs.
Although ETFs have been around for more than 25 years, misconceptions still abound, such as:
Definitely not! ETFs can be a valuable part of just about any investment portfolio. Buy-and-hold investors shouldnt feel pressured to change their behavior just because they choose to invest in ETFs.
Another myth. All ETFs can be bought and sold through a Vanguard Brokerage Account, just like individual stocks.
Before you make any decisions,consider your asset allocationhow you divide your money among stocks, bonds, and cash. That will drive your returns more than any specific investment selection.
Beyond that, stock ETFs are well-suited for almost any investor, including buy-and-hold investors saving for a long-term goal, such as retirement. In fact, if you have a long time horizon, you may want to hold ahigherpercentage of stock ETFs in your portfolio to give you the best opportunity for growth. And even retirees may want to use a small percentage of stock ETFs in their portfolios to help offset inflation.
The following tables match Vanguard stock ETFs to their Vanguard index mutual fund counterparts.
For global diversification split between U.S. and international exposure
Total International Stock Index Fund Admiral Shares
Dividend Appreciation Index Fund Admiral Shares
FTSE All-World ex-US Index Fund Admiral Shares
FTSE All-World ex-US Small-Cap Index Fund Admiral Shares
Global ex-U.S. Real Estate Index Fund Admiral Shares
International Dividend Appreciation Index Fund Admiral Shares
International High Dividend Yield Index Fund Admiral Shares
Emerging Markets Stock Index Fund Admiral Shares
*Source: Morningstar, Inc., as of December 31, 2018.
**Very few Vanguard fundscharge fees when you buy and sell shares. The fees are designed to help those funds cover higher transaction costs and protect long-term investors by discouraging short-term, speculative trading. Fees vary from 0.25% to 1.00% of the amount of the transaction.
You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free) or through another broker (which may charge commissions). See theVanguard Brokerage Services commission and fee schedulesfor full details. Vanguard ETF Shares are not redeemable directly with the issuing fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There may be other material differences between products that must be considered prior to investing.
Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. These risks are especially high in emerging markets. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
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