Exchange-traded funds, commonly referred to as ETFs, are investment companies that fall under thes same legal classification as mutual funds and unit investment trusts. They can be either open-end companies or closed-end companies. ETFs can give you the flexibility of investing in an individual stock, but with the added benefit of a diversified portfolio of holdings, like an index mutual fund. If an ETF matches your investment objectives and temperament, you can buy one for your Roth IRA.
A Roth IRA is a type of individual retirement account. If differs from a traditional IRA in that you cannot deduct your contributions, but your investments in your Roth account grow tax-deferred as long as they remain in the account, and qualified withdrawals are tax-free. The Internal Revenue Service prohibits putting life insurance or collectibles in your Roth IRA. Other than those restrictions, you can invest in almost anything you wish for your Roth IRA, including ETFs.
There are a number of different kinds of exchange traded funds, but most ETFs attempt to mimic a particular market index, such as the S&P 500 Composite Price Index, in terms of composition and performance. The fund might include a weighted average of stocks of all the companies that are included in that index, or it might only invest in a sample of the companies. The ETF's method of investing will be expressed in its prospectus. The prospectus contains additional pertinent information about the ETF's objective and management philosophy. You should request and read the prospectus before investing in an ETF for your Roth IRA.
ETFs have a variety of benefits that may make them suitable for inclusion in your Roth IRA investment, depending on your investment objective and temperament. You can by ETFs on major exchanges through your brokerage account in much the same way you buy stocks. Most ETFs pay dividends, according to the New York Stock Exchange. ETFs provide instant diversification, are readily tradeable and can be used for short-term trading, long-term investing or as a hedging strategy. When you hold ETFs in your Roth IRA, any dividends or capital gains they produce enjoy the same tax-deferral benefits as all other investments in the account.
ETFs vs Index Funds
ETFs share a number of qualities with index mutual funds, but they also have some significant differences. Both types of investments seek to mimic a particular index. Both ETFs and index mutual funds are quoted by their net asset value, but the NAV for mutual funds is typically calculated only once per day, after the market has closed. The NAV of ETFs are calculated much more frequently. For example, ETFs listed on the New York Stock Exchange are calculated every 15 seconds.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.