You know I am a big believer that a Roth Individual Retirement Account (IRA) is the best way to save for retirement. And for my money, I think Exchange Traded Funds (ETFs) are an ideal way to invest the money in your IRA.
Just like a mutual fund, an ETF is a portfolio of dozens and often hundreds of different stocks or bonds. In fact, some companies offer ETF and mutual fund versions of the same portfolio.
The main difference has to do with how the share price is calculated. As you may know, a mutual fund’s share price is set once a day, after the close of the trading day, based on the closing value of all the securities in the portfolio. So for example, if you placed an order at 11 a.m. on a day when the stock markets are open, your purchase price would be based on the closing value of the portfolio (4p.m. ET).
An ETF trades just like a stock: If you place an order at 11 a.m., your trade will be processed based on the ETF’s share price at 11am. That can be a big deal if for whatever reason the markets are skyrocketing or tanking.
The Indexing Advantage
The vast majority of ETFs track a benchmark index, rather than rely on a manager(s) to actively choose what the portfolio owns, and when it buys and sells specific investments. Study after study has shown that over the long-term, index portfolios tend to perform better than most actively-managed portfolios. Sure, there are plenty of no-load mutual funds that are index funds. They can be a fine way to go, but for many investors, ETFs have a practical edge over mutual funds.
My top two reasons for why I recommend ETFs over no-load mutual funds for your retirement savings:
You need less money to get started. Most mutual funds require you to plunk down at least $1,500 or more to get started investing. But most discount brokerages only require that you purchase at least one share of an ETF to get started. That can be just $50. Maybe even less. So ETFs are a terrific way to start investing $50 or $100 (or more!) on a regular schedule: you can set up an automatic monthly transfer from a checking account into your account at a discount brokerage that is used to buy more shares of an ETF.
They are also ridiculously cheap to own. There are two costs of ETFs you need to be aware of. Just like a stock, there is typically a commission charged every time you buy or sell shares. Some discount brokerages charge just $10 or so per trade, but if you’re investing $50 or $100 a month that’s still way too much. The good news is that most discount brokerages offer a bunch of commission-free ETFs. So it’s pretty easy to build a diversified portfolio of ETFs and not pay a penny of commission.
The second fee for an ETF is the annual expense ratio. Just like a mutual fund, ETFs charge this fee to every investor. But here’s the thing: ETFs typically have some of the lowest expense ratios, often lower than even inexpensive no-load index mutual funds. There are many ETFs with annual expense ratios below 0.10%. Some even charge as little as 0.03%. I hope you realize what a huge deal that is. Let’s say you invest $1,000 in a mutual fund and $1,000 in an ETF, and both investments have an annualized gain of 5% for 20 years. Exactly the same. But the mutual fund’s expense ratio is 1% and your ETF’s expense ratio is 0.05%. At the end of 20 years your fund account would be worth nearly $2,200. The lower-cost ETF investment would be worth more than $2,625. That’s a difference of more than $400!
We can’t control how the markets perform, but we are in total control of the fees we pay to invest. ETFs are a terrific way to gain instant diversification for a rock-bottom fee.