Exchange-traded funds combine the features of an index fund with an individual stock. The set-up can mean lower fees and fewer tax liabilities compared with other types of investment. Choosing the best exchange-traded funds involves deciding how much risk you are prepared to take and how much return you expect, then considering the costs of buying into the fund.
The concept of an exchange-traded fund is the same as an index fund. That is, the money invested in the funds is used to buy and sell stocks from a particular stock exchange in a way that is designed to track the entire exchange. In other words, if the exchange as a whole increases in value by five percent, the stocks held by the fund should increase by five percent as well.
The difference between an exchange-traded fund and an ordinary index fund is that investors buy and sell their stake in the fund as if they were stocks. This means the price of a stake in the fund varies with demand and supply and doesn't necessarily move in line with the tracked exchange. The pricing is based as much on how people expect stocks on the exchange to perform in the future as on their current and past performance.
Arguably the best exchange-traded funds benefit is the tax treatment. Unlike some types of funds, investors do not have to pay taxes each time the fund itself sells a stock at a profit. Instead, the investor only pays capital gains tax on the ownership stake itself, as and when she sells the stake at a profit. The downside is that there is a commission charge every time the fund buys or sells stocks.
The main key to choosing the best exchange-traded funds is checking which index it tracks. This is largely a case of risk vs reward: you may have to choose between a reliable index that is most likely to make a small but relatively secure gain, and an index that tracks a more volatile exchange where gains can be high but are less predictable. The latter option may be more common in funds that track exchanges in developing countries.
Costs are another important factor in selecting the best exchange-traded funds. Aside from the capital gains tax and the commission charges, the main cost is the expense ratio. This is the fee charged by the operators of the fund for handling the money and tracking the index. The expense ratio is usually expressed as a simple percentage of your total investment, and one estimate has the average expense ratio at 0.74 percent. Generally the more unusual the exchange being tracked, the higher the expense ratio.