You might be asking yourself, "What are ETFs?" as these three letters have become a hot investing buzzword in recent years. Exchange Traded Funds, or ETFs, are investment alternatives that combine characteristics of an indexed mutual fund and market-based securities. ETFs represent a broad range of stocks or bonds that follow some type of index, which could be a stock exchange index like the S&P 500, a sector of the economy or a region of the world.
But, unlike mutual funds, ETFs can be traded just like stocks. With an ETF, you can get the diversification of an index fund and the flexibility of a stock. You can buy ETFs on margin through your brokerage account, and you can take long and short positions by dealing in ETF options.
As far as your long-term portfolio is concerned, you can focus your investment in ETFs on a specific index. Or, you can diversify with an ETF that covers a certain sector. Since they are passively managed, ETFs have much lower expense ratios than mutual funds, but you have to pay a commission when you buy and sell ETFs, just as you would with stocks.
Types of ETFs
All the major stock indexes in the United States have ETFs that follow them. One of the most widely known is the Spider (Standard & Poor's Depository Receipts or SPDR) that tracks the S&P 500 index. Diamonds (DIA) follow the Dow Jones Industrial Average, and Cubes (QQQ) follows the NASDAQ 100 index.
You can choose from broad-based ETFs that follow the indexes for large US companies, small and mid-size companies, and growth and value stocks. Sector ETFs follow a specific group of industries such as technology, finance, energy or health care. In addition to ETFs for stocks, there are also fixed-income ETFs that follow the indexes for corporate and Treasury bonds.
If you want to expand your portfolio to include investments outside the US, go with international ETFs. Some are broad-based global ETFs, and others are more specific to certain countries, regions or emerging markets.
Pros and Cons of ETFs
Since ETFs consist of a broad range of securities, they help diversify your portfolio. At the same time, ETFs can be more focused. You'll find ETFs for growth and value stocks, large and mid-capitalization companies, different sectors of the economy and foreign markets.
When you buy shares in an ETF, you are buying the market for the particular index the ETF follows, so you are diversified in the sense that you have a share of a relatively large number of securities. But you are still exposed to the market risk applicable to that index. The degree of risk depends on the type of ETF you choose, and whether or not you diversify your investments among several different ETFs.
ETFs provide liquidity in that you can buy and sell as often as you like, and you do not need a large amount of money to invest in ETFs, unlike mutual funds, which tend to require minimum investments. The expense ratio, or expenses for administering the fund as a percentage of assets, is also on average much lower than mutual funds.
ETFs can be considered tax efficient in that you are generally subject to capital gains tax only on your profit when you sell your shares in the ETF. In a mutual fund, you are subject to taxes on the capital gains the fund manager distributes to the mutual fund shareholders, when securities are sold to adjust the mutual fund's position or when shareholders redeem shares.
Although ETFs have a low expense ratio, brokerage commissions are charged each time you buy and sell. If you make frequent trades, the commissions will add up. On the other hand, if you invest larger amounts at less frequent intervals and use an online discount broker, the commissions may not have as much of an impact on your gains.
Who Should Consider ETFs?
ETFs can be attractive to investors who make relatively large and infrequent investments, which minimizes the brokerage commissions. Investors who follow a buy-and-hold strategy with a long-term investment horizon may like the prospect of a broad-based ETF that provides a yield equal to a major stock exchange.
Since there is no minimum investment requirement for an ETF, as there could be for a mutual fund, investors with a relatively small amount of money can get into the market with a diversified investment by purchasing shares of an ETF.
Because of the brokerage commissions, ETFs may not be appropriate for systematic investors who want to make regular deposits to an investment account, such as in a dollar-cost averaging strategy. Traders who make frequent transactions can take advantage of the liquidity of ETFs if they trade a sufficient volume to justify the commissions.
ETFs can be a good way to diversify a portfolio among large, mid- and small-cap companies, different sectors of the economy and foreign markets, without the risk and work involved in selecting individual stocks. By investing in ETFs instead of mutual funds, you have the flexibility to adjust your positions and the share of your portfolio in different indexes according to shifts in economic and market conditions in the US and worldwide.
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