Many investors are looking for the next great deal. But before committing your hard-earned money to something new, it is essential to understand exactly what you’re buying, how it works, and the potential risks and rewards it may carry.
One type of investment that’s been attracting increased attention in recent years is the Exchange-traded fund, or ETF. These investment vehicles offer a way to diversify your portfolio without having to pick individual stocks, making them an appealing choice for both beginner and experienced investors.
Interest in ETFs has surged following headline-making market events, such as the GameStop frenzy. This incident started a broader conversation about what’s inside these funds and how they react to market volatility.
Let’s take a closer look at ETFs: what they are, how they function, and the pros and cons of including them in your investment strategy. By the end, you’ll be equipped with the insights needed to determine whether ETFs align with your financial goals and risk tolerance.
What is an ETF?
According to NerdWallet, ETFs “are a type of investment fund that offer the best attributes of two popular assets: They have the diversification benefits of mutual funds while mimicking the ease with which stocks are traded.”
These investments are called “exchange-traded” because they are traded on an exchange, just like a stock, susceptible to the same daily fluctuations in price as shares are bought and sold on the market.
ETFs can contain many different investments, such as stocks, commodities, and bonds with varying levels of risk. They are designed to offer diversification, liquidity, and low costs. As always, it is important to do your research on particular holdings before investing.
ETFs vs Mutual Funds
Trading and Pricing
- Exchange-traded funds are traded on stock exchanges just like individual stocks. This means you can buy or sell them throughout the trading day, and their prices fluctuate based on market demand.
- Mutual funds, on the other hand, are only priced and traded once per day after the market closes.
Management Style
- Exchange-traded funds are typically passively managed and track an index, such as the S&P 500.
- Mutual funds can be either actively or passively managed, but many are actively managed with a team of professionals aiming to outperform the market.
Costs and Fees
- Exchange-traded funds often have lower expense ratios and are considered more cost-effective.
- Mutual funds may have higher fees, including management fees and commissions.
Tax Efficiency
- Exchange-traded funds are generally more tax-efficient, which helps minimize capital gains distributions.
- Mutual funds tend to trigger more taxable events, especially in actively managed versions.
How Does ETF Investing Work?
Here is an abbreviated explanation from NerdWallet:
- An ETF provider considers the universe of assets, including stocks, bonds, commodities, or currencies, and creates a basket of them with a unique ticker.
- Investors can buy a share of that basket, just like buying shares of a company.
- Buyers and sellers trade the funds throughout the day on an exchange, much like a stock.
You can purchase these types of funds through online brokers and traditional broker-dealers.
What Are the Advantages of ETFs?
Diversification
ETFs include not only a variety of investments such as stocks and bonds, but they can also encompass a wide array of industries and sectors, allowing an investor to spread their risk even further.
Easy to research, buy, and trade
Since ETFs trade like a stock, it does not take much effort to research the different holdings of an ETF. Likewise, the price activity of an ETF is easily looked up using its ticker symbol and is available for purchase and trade on many electronic trading platforms like E-Trade.
Tax-efficient
Investors have more control of when they incur taxes with ETFs as, most often, capital gains are only realized when an ETF is sold.
What Are the Disadvantages of ETFs?
Potential for High Cost
Buying and selling shares of ETFs may result in brokerage commissions and may be high, especially for actively managed ETFs.
Lower Yields
Since ETFs typically track a broader market, there’s less volatility on a day-to-day basis which, in turn, can limit the amount of money you can make, especially in short-term trades.
Liquidity
Being able to turn your ETF into cash fast may not be easy. Due to low trading interest in some ETFs, getting rid of it may be difficult.
Is ETF Investing Right for You?
Exchange-traded funds can be a great fit for many individuals, including retirees, due to their low costs, diversification, and flexibility. They offer access to a broad range of assets in a single investment, often with lower fees than mutual funds. However, not all ETFs are low-risk, so it’s important to choose wisely.
As with any investment decision, you must do your research. If you feel ETFs may be a good addition to your portfolio, contact us today so we can work with you to determine the best ETFs for you.
