Liquid or Cost Effective
Mutual Funds 2.0...
For decades, mutual funds were the only way individual investors could gain access to a diversified portfolio without having to buy shares of individual companies. The time and cost involved in having to build a portfolio of hundreds of companies would prevent most individual investors from having a broad-based investment portfolio. In the 90s, a new investment product called an exchange traded fund (ETF) provided a new way for investors to diversify with cost effectiveness and accessibility.
ETFs are often referred to as index funds, as they contain stocks included in a list of companies that meet certain criteria. Because the holdings of an index fund are determined by the parameters of the index, it eliminates the need to hire fund managers to select individual stocks. This provides an element of cost effectiveness for ETFs as compared to typical mutual funds, which utilize managers. Also, because ETFs are traded on stock exchanges, they can be bought or sold at any time during market trading hours, unlike mutual funds which are bought and sold at the daily closing net asset value (NAV).
With an increasing presence, there are now around 2,000 ETFs on the market, which may make it seem overwhelming for an individual investor trying to decide which type of investment may be best for them. Though there are a range of differences between ETFs, this edition of Markets Demystified will focus on the trade offs between cost effectiveness and liquidity. Liquid assets have a consistently high number of buyers and sellers, which means that a seller is likely to find a buyer. When it comes to stocks, high liquidity can also result in smaller bid-ask spreads. The bid-ask spread is the difference between the lowest price a seller is willing to accept and the highest price a buyer is willing to pay. Stocks with lower liquidity often have wider differences in the bid-ask spread.
For traders who have short-term holding periods, liquidity may be a desirable feature of an investment product. Smaller spreads associated with high liquidity levels lets traders have a higher degree of certainty about the price they will either pay or receive during a transaction.
However, even if separate ETFs have the exact same holdings, ones with higher liquidity can command a higher expense ratio, which is the expense incurred by the investor to own the ETF. Although ETFs with relatively higher expense ratios can be more cost effective than mutual funds, they can be more expensive than comparable funds with less liquidity. For the average retirement investor who has a long-term time horizon as compared to shorter-term traders, and who don’t need to trade in and out of a fund quickly, less-liquid, more cost effective funds may be the best option. Lower expense ratios can allow long-term investors to keep more of the fund’s gains and pay less in fees.
June 21, 2023
Markets Demystified is published the first and third Wednesdays of each month, and explores how stock market investing can relate to personal finance.
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