Investors begin their journey to financial freedom in an unlikely place: a college bar on their 21st birthday, where they probably ordered a long island iced tea as a way to fall into a drunken stupor. The concoction contains a little bit of everything, and most importantly for college students, it’s cheap—not unlike what exchange-traded funds (ETFs) do for first-time investors.
Viewing long island iced teas and ETFs through this same lens can serve as a prelude to personal finance.
What are exchange-traded funds (ETFs)?
An exchange-traded fund (ETF) lets everyday investors access a basket of stocks, bonds, or other asset classes in a single asset. By holding an ETF, investors reap the same diversification benefits inherent in a mutual fund but at a fraction of the cost. These ready-made solutions also trade during regular market hours, so there’s no need to wait until after hours when markets open for mutual funds.
Such a friendly structure has elicited considerable enthusiasm over the past two decades. Some estimates suggest global ETFs now oversee more than $9 trillion in assets, and that number is expected to grow.
But the benefits extend well beyond its framework.
Breakdown of ETF Benefits
Let’s illustrate the advantages with an example. Each ingredient in a long island iced tea will map to one of the primary benefits of an ETF.
Tequila (Tax Efficiency): Tequila’s knack for bringing out the best, and sometimes the worst, in people remains undefeated. It’s like clockwork when you drink the distilled agave. The first sip burns, but by the second and third, you feel quite good.
Most investors would say they want this same efficiency from their assets, and they can get that with an ETF. It does this by creating fewer taxable events than a comparable mutual fund and more opportunities for tax-loss harvesting. Now you may be asking: tax-loss what? Think of tax-loss harvesting like this quote from Kareem-Abdul Jabbar, “You can’t win unless you learn how to lose.” With tax-loss harvesting, investors will sell an ETF at a loss to offset a gain elsewhere in their portfolio. Doing so puts them in a better position over the short and long term.
Vodka (Lower Costs): Costs are a significant factor in any decision, from buying liquor to making an investment. We all remember buying a plastic bottle of vodka to save money in our early 20s (over 21, of course). The same should apply to investing. And for the most part, ETFs fits everyone’s budget. Since they are passive vehicles—meaning ETFs track an index, sector, or thematic factor—investors can avoid 12b-1 and management fees charged by traditional mutual funds.
For example, some of the cheapest ETFs charge about zero to a few basis points, while a typical mutual fund might run as high as two percent.
Rum (Flexibility): Mai Tai. Mojito. Pina Colada. Long Island Iced Tea. You get the picture; some liquors mix well with anything. Having flexible investments can be equally rewarding. Investors can buy and sell ETFs throughout the trading day when a traditional open-ended fund stays out of commission until after hours.
Triple Sec (Diversification): Not enough can be said about diversification. It is the cornerstone of modern finance and most sound investment plans. A well-diversified portfolio consists of investments in different sectors (tech, energy, etc.) or asset classes (stocks, bonds, etc.) that work together to reduce risk and maximize returns. (You can think of diversification like a Pokemon battle)
For that reason, many people invest in ETFs over individual stocks. An ETF brings instant diversification because it tracks an index, specific sector, or basket of assets. Of course, that means investors may have exposure to a mix of well-known and lesser-known names. Likewise, triple sec may not make a cocktail memorable, but it’s certainly a necessary ingredient in many memorable cocktails.
Gin (Transparency): You know what you get with Gin, making the botanical-rich liquor the most transparent alcohol. Each sip causes you to gag like the first time you took a shot of vodka in your friend’s basement. Or, if you’re like me, there are few drinks more enjoyable than a gin and tonic.
The same can’t be said about an ETF, but it still provides more transparency than other funds. Investors know what stocks enter and exit the fund each day, unlike a mutual fund, which has no obligation to disclose individual holdings.
Soda (Simple): ETFs boast a long list of benefits, including diversification, transparency, and tax efficiency, amongst more. We can sum this up in one word: simple. Beginner investors who have a few extra dollars will find ETFs an easy starting point in their financial journey. Even those well into their 60s can benefit from the off-the-shelf solution. So while you will outgrow a long island soon after college, you and your portfolio should always have a place for an ETF.
Much like this simple investment, soda serves a similar purpose.
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