It might sound too good to be true—a single investment fund that:
- Is surprisingly tax efficient and transparent
- Can be used to diversify your portfolio
- Can even save you money
But a fund with each of the benefits above does exist, and it is called an ETF (Exchange Traded Fund). To prepare you for making informed decisions about the increasingly popular option, let’s take a closer look at the ups and downs of ETFs.
About Exchange Traded Funds
In a little over a decade, the selection of ETFs has grown from just a handful
), and the number keeps growing. In that time, they have proven to be a low-cost, tax-efficient alternative to active management. ETFs share many qualities with both common stock and open-ended mutual funds:
- Like stock, they can be bought and sold throughout the day, purchased on margin, and sold short.
- Like mutual funds, they’re comprised of a combination of stocks, commodities, bonds, currencies, and more, giving them great diversity.
However, instead of trending with a specific sector or type of investment the way many mutual funds do, most ETFs are passively managed or built to mirror the activity of an index (such as the Dow Jones, NASDAQ, or S&P 500). As a result, ETFs are not meant to outperform their associated index; rather, they are intended to simply match the pace of the index.
It’s important to note that some ETFs may be actively managed, which means the portfolio manager varies the holdings or sector allocations of the benchmark index. As a result, the returns of actively managed ETFs may vary from the benchmark.
For the purpose of this article, we will focus primarily on passively managed ETFs.
The ETFs Role In A Portfolio
The fact that ETFs are comprised of a bundle of securities gives them the benefit of instant diversification, similar to mutual funds. In fact, investors who used to buy stocks in 40 different companies to diversify company risk can achieve the same level of diversification in just one ETF. Some investors have been known to build all-ETF portfolios, while others prefer to use ETFs to fill in the gaps of their current portfolio holdings.
If you do a little research on ETFs, you’ll notice immediately that no two are the same. They’re similar in that they’re all comprised of a number of stocks, bonds, and more; but the percentages of these holdings that make up an ETF vary greatly because different ETFs track different indices.
ETFs that track the same index will have similar portfolios, but each will differ in a small way (different expense ratios, fund administrator, etc.). Small differences do not mean one ETF is significantly better than the other. If two ETFs were built to keep pace with a corresponding index, they are designed to perform roughly the same over time.
To decide if investing in ETFs is right for you, let’s explore some pros and cons for a more complete picture of how they work…
- Reliable Source of Market Returns
As mentioned, many ETFs are built to match the performance of a related index. Generally, while an ETF is not likely to outperform a given index, it probably won’t underperform it either. This feature makes ETFs part of what’s called a “passive management strategy.”
- Incredibly Cost Effective
For investors who can commit to a hands-off approach, passively managed ETFs typically save management fees, transaction costs, and taxes due to lower portfolio turnover. And because replicating an index is far easier and more efficient than attempting to outperform it.
- Uniquely Transparent
ETFs are required to disclose their holdings on a daily basis. In contrast, mutual funds are only required to disclose their holdings once each quarter, and the reports can still be as much as a month behind. Being fully up to speed can eliminate a large amount of anxiety for some investors.
- Market Risk
The biggest drawback to ETFs: if the market has a rough day, so does your ETF. For example, if NASDAQ drops 5%t in one week, you can expect your NASDAQ ETF to do the exact same. That’s why it’s imperative to treat ETFs as part of a long-term investment strategy. To reap the benefits of your investment, you must be patient enough to ride out the rough spots.
- ETF Trading Fees
While it’s true that passively managed ETFs are cost-effective compared to their actively managed counterparts, neither are immune to any fee or commission you would typically pay to buy or sell securities through your brokerage firm. Commissions can add up quickly, so (like with any security) it’s best to avoid buying and selling ETFs on a regular basis.
While ETFs are still a relatively small share of the market, they continue to grow in popularity each year, and their continued climb is a trend every investor needs to watch. If you’re a patient investor who expects you’ll be able to leave ETFs alone, they can be a great choice. But, if you prefer to constantly micromanage your portfolio, they will be a serious drain.
Please give me a call if you’d like to discuss how ETFs might fit into your strategy. I’m always happy to help.