When your parents were investing, their advisors likely steered them toward tried-and-true vehicles like mutual funds. But in recent years, ETF advantages have provided a whole new avenue for investing.
What’s an ETF, and how does it work? This article will explain the types and advantages of ETFs, helping you evaluate whether these investment vehicles have a place in your portfolio.
What’s an ETF?
An ETF, or exchange-traded fund, uses money from investors to purchase a collection of stocks, bonds, or other securities. As an investor, you can buy and sell ETF shares just as you would buy and sell stock shares from any major stock exchange.
Many ETFs seek to track with a market index such as the S&P 500 or the Dow Jones, though there are other types of ETF as well.
ETFs are managed by a fund company. To invest, you’ll pay a fee called an “expense ratio,” which covers the percentage of the assets that the company is managing.
In many cases, the ETF requires little attention, which translates into a low expense ratio. However, if you want your fund manager to actively manage your investment and perform diligent research, the fee will be higher.
Though ETFs have been around since 1993, their popularity did not spike until after the 2008 recession. In 2008, Americans had invested roughly $530 billion in ETFs. But today, that number has risen to more than $4 trillion.
What Are the Different Types of ETFs?
There are many different types of ETFs, including these common examples:
Stock ETFs
These are among the most common types of ETFs. Stock ETFs hold a portfolio of stocks and can be bought and sold just as you would with individual stocks. Stock ETFs can be publicly traded on an exchange throughout the trading day.
Index ETFs
Index ETFs are designed to track a particular market index, such as the S&P 500 or Nasdaq. Frequently, Index ETFs are organized around specific sectors or industries, though they can also cover specific classes of stocks, as well as foreign or emerging markets equities.
Bond ETFs
Bond ETFs are those that are invested in bonds or other fixed-income securities. Bond ETFs can be broad and diverse and contain bonds of varying types and maturity dates, though they can also focus on bonds of a particular type.
Commodity ETFs
Commodity ETFs hold actual physical commodities, such as natural resources or precious metals. It’s not unusual for these ETFs to combine the physical commodity with a related investment, such as combining agricultural goods with a manufacturing company.
Currency ETFs
Currency ETFs are helpful for investors looking to gain exposure to the foreign exchange market. They can focus on a single currency or a collection of various currencies and usually track the most popular international currencies (e.g., the euro, Japanese yen, etc.).
Inverse ETFs
When there is a decline in the value of a group of securities, investors can use short selling to gain profits. This process uses various derivatives and results in the formation of an inverse ETF.
Actively Managed ETFs
An actively-managed ETF is one that is handled by a fund manager who directly participates in the allocation of portfolio assets. Actively managed ETFs will typically cost more to maintain since a manager or investment team will be actively involved in researching and adjusting the stocks in the fund.
Leveraged ETFs
A leveraged ETF contains financial derivatives designed to leverage investments and maximize gains. Leveraged ETFs are typically used for short-term investments by those looking to take advantage of changes in the major stock indexes.
Real Estate ETFs
Real Estate ETFs can hold actual real estate and contain things like real estate investment trusts (REITs), firms, and development companies.
Understanding ETF Advantages
Investors commonly point to the following ETF advantages:
Lower Costs
ETFs trade just like stocks. This easy access means that you can typically purchase a diversified portfolio for the same low commission as a regular stock portfolio — and compared to mutual funds, ETFs have a lower expense ratio.
Investors can get even better deals when they choose a passively-managed ETF, which requires minimum input from a broker or fund manager.
Simple Diversification
Because ETFs are essentially a bundle of assets, investors have the potential to achieve diversity quickly and easily. Plus, the wide array of ETF types means that investors can select a variety of different types of ETFs to add more diversity to their portfolios.
Greater Transparency
Mutual funds and hedge funds only report their performance quarterly, but an ETF will provide daily reports, which gives investors up-to-date data on how their portfolio is performing. This regular reporting also makes it easier to make decisions about these assets to optimize their earnings potential.
High Degree of Liquidity
Mutual funds can only be sold at the end-of-day closing price, but ETFs can be bought and sold throughout the day on secondary markets. This flexibility means that investors can take advantage of market volatility and use ETFs in other stock trades.
Accessibility to Niche Markets
Historically, it’s been difficult for individual investors to gain exposure to certain markets, including foreign exchange, emerging market equities, and cryptocurrency. ETFs offer investors a window into these markets, allowing you to gain exposure to a broader range of assets than with other investment vehicles.
Scalability
Because ETFs trade like stocks, they can be purchased in both small and large amounts. This divisibility means that investors can purchase small positions with no minimum requirements and use these small positions to scale in and out of a position as their strategy dictates.
Tax Efficiency
One of the most talked-about ETF advantages has to do with tax efficiency. Since many ETFs are designed to follow a market index, they typically don’t provide large capital gains or other income that owners receive each year. Investors, therefore, have more control over when they incur taxes.
ETFs also overcome rules that forbid investors from selling and claiming a loss on a security if they purchase a similar security within a 30-day period. This freedom helps mitigate loss and reduce an investor’s overall tax liability.
The Disadvantages of ETFs
It would be wrong to say that there are no challenges associated with ETFs. Common drawbacks to ETFs include:
Over-Diversification
It’s possible to become too diverse. The assets represented in an ETF may or may not represent the best investments, and in some cases, it may be more advantageous for investors to select individual stocks instead of an organized fund.
Exposure to Risk
While ETFs allow investors to gain exposure in niche markets, this also means that they’ll be navigating unfamiliar territory. Not every investor will be familiar with the performance and risks associated with foreign exchange markets or emerging market equities, which can result in greater vulnerability.
Less Portfolio Balance
Index ETFs are designed to track a market index, but that can be misleading to their owners. As the index improves, so does your ETF, but that doesn’t always reflect the performance of individual stocks within the fund.
For example, it may be possible for an ETF to contain a disproportionate number of overpriced stocks and few bargain stocks. Investors will have to be diligent to ensure that they balance their portfolios to mitigate these changes.
ETFs and Your Broader Investment Strategy
ETFs can be a great investment vehicle for those who:
- Want low-cost exposure to diverse markets
- Want to take advantage of ETF tax efficiency
- Want to use ETFs while day-trading
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