Is an ETF—which, much like a mutual fund, holds shares of stocks, bonds or other investments, but can be traded like shares of stock during the trading day—right for your portfolio?
In the quarter-century since the first exchange traded fund—or ETF—was launched, these innovative investment vehicles have proven remarkably popular and experienced stratospheric growth.
The following basic statistics tell the tale:
Advantages of ETFs
Much of the growth in ETFs is from increased popularity of investing in passively managed index funds,which track an index or market benchmark like the S&P 500. Passive management means the ETF seeks to replicate the holdings of the index rather than actively selecting stocks or bonds for the fund.
To capitalize on the demand from both individual investors and financial advisors, firms issuing ETFs have continued to add more choices.
Here are a few of the other benefits ETFs can potentially offer investors when contrasted to mutual funds, which are one of the most directly comparable investment vehicles to ETFs:
- Low costs. Indexing is considerably less costly than active management. And so the cost structure of ETFs is generally lower than that for mutual funds, which often translates to lower costs compared to mutual funds. While there are some ultra-low-cost index mutual funds, many of these have high initial investment requirements—unlike ETFs.
- Trading like stocks. As previously mentioned, ETF shares can be bought and sold during the trading day. Once a trade order is submitted, investors will know the price at which they bought or sold shares almost instantly. In contrast, mutual fund trades are placed during the trading day but not executed until after the markets close. In times of extreme market fluctuation this difference in timing can impact the value received from a sale or the price paid when making a purchase.
This also allows investors to use tools such as stop orders to set a floor on an ETF, which trigger if the share price of an ETF falls to a pre-determined level. This tool—not available with mutual funds—can help manage your risk in holding an ETF.
- Transparency. Unlike mutual funds, the underlying holdings in an ETF are transparent and can be viewed by investors daily. Mutual funds are only required to report their holdings periodically during the year.
- Tax-efficiency. Due to their structure, ETFs are generally more tax-efficient than mutual funds, as these funds tend to make fewer taxable distributions than similar mutual funds in most cases. There will be capital gains generated if an ETF or a mutual fund is sold for a higher value than when it was purchased.
- No investment minimums. Some mutual funds may require a minimum initial investment, but—while there may be commissions to buy or sell—you can purchase a single share of an ETF.
- A wide range of investment options. Over the years, ETFs have ventured beyond their roots in traditional, vanilla indexes to a wide range of strategies, styles and benchmarks. These include various global benchmarks, industry sectors, smart beta strategies based on a set of rules surrounding a benchmark and even active ETFs. Due to their structure, ETFs can often serve to provide investors with greater liquidity than both mutual funds and even than some of the underlying holdings within the ETF. Additionally, there are ETFs that invest in specific industry sectors and various countries, as well as a growing number of actively managed ETFs.
Talking to your advisor about ETFs
Among the biggest users of ETFs are financial advisors investing on behalf of their clients, and as a client, you should always feel comfortable asking questions about how and why your advisor makes certain recommendations on your behalf. Because underlying holdings in an ETF are transparent and can be viewed by investors daily, be sure to have your advisor show you what you can be looking for if you want that level of detail.
If you are interested in potentially bringing ETFs into your investment strategy, a seasoned financial advisor can help you research the fund or fund(s) that will complement your existing diversified portfolio and strategize allotments that best fit your short- and long-term financial goals.