If you’re buying exchange-traded funds, or ETFs, in an individual brokerage account, the process is as simple as choosing the fund you want and placing the order. ETFs trade like stocks and you can buy and sell them throughout the day as you would any other security. In most cases, you’ll pay standard broker commissions on ETF trades. If you have an account with a mutual fund company offering proprietary ETFs, however, you may be able to make commission-free ETF trades.
Because ETFs trade like stocks, it is possible to leverage funds and buy and sell options in an individual brokerage account. ETFs can also be bought on margin in individual accounts. Those strategies aren’t available with index and mutual funds, which is another reason ETFs continue to gain popularity with investors.
ETFs and retirement accounts
Whether or not you can hold ETFs in your retirement account depends on what type of account you have. Most employer-sponsored 401(k) plans don’t offer ETFs, despite their huge popularity with individual investors—U.S. assets held in ETFs exceeded $3 trillion, up by over 30% from the previous year.
There are many reasons most employer-sponsored plans don’t offer ETFs. ETFs are extraordinarily tax efficient, which is a huge advantage for individual investors, but matters very little for long-term, tax-deferred investments like retirement accounts. This is one reason why plan managers don’t focus too heavily on ETFs when index funds and traditional index funds offer similar exposure and returns.
In addition, ETFs are traded throughout the day, which means they are subject to constant daily price fluctuations, similar to stocks. Index and mutual funds, the most common investment options in employer sponsored plans, are priced just once daily, after the market closes. Switching from a single, fixed daily price to a fluctuating one presents a huge recordkeeping and technology hurdle for plan administrators.
Finally, ETFs are traded in whole shares, unlike mutual funds, which can be bought in fractional shares. Mutual funds are a better fit for 401(k) plans, which typically rely on regular automatic contributions, because the entire contribution can be allocated, even if it results in partial shares.
If you have an individual retirement account, either a traditional IRA or a Roth, on the other hand, ETFs are a great fit. In order to hold ETFs in your IRA, however, you need to open it through a brokerage. You can’t buy ETFs with an IRA held by your bank.
Keep in mind that you don’t have the same flexibility to buy ETFs on margin in an IRA, and you can’t buy ETF options with IRA funds, either. These strategies are only available in taxable accounts.
If you do want to add ETFs to your IRA, commission costs aren’t the only thing that drag down returns. Since ETFs trade on the exchange, you’ll have to deal with spread, which is the difference between the bid and ask price. For small, infrequent trades, this isn’t such a big deal. If you make large, frequent trades, however, the accumulated spread costs can be substantial.
ETFs typically have among the lowest expense ratios of all mutual funds; many can be held for fees as low as $30 per $10,000 invested. This can make a huge difference in an IRA, where assets are held for long periods of time. For that reason alone, holding ETFs may be a wise choice as part of a diversified retirement portfolio.