Investors looking for a diversified portfolio that is easy to manage often turn to exchange-traded funds (ETFs). An ETF is an investment vehicle that combines the diversification of a mutual fund with the flexibility of a stock. Here is how it works.
What is an ETF?
An ETF is a basket of securities that trades on an exchange, much like a stock. The basket can contain a mix of stocks, bonds, commodities, or other assets. The ETF’s value is derived from the combined value of the underlying securities.
ETFs were first introduced in the early 1990s and have since gained widespread popularity among investors. As of November 2021, there were over 8,700 ETFs with over $7.9 trillion in assets under management (AUM) worldwide, according to the Investment Company Institute (ICI).
Types of ETFs
There are several types of ETFs available to investors. For example, equity ETFs track a specific stock index or sector, such as the S&P 500 or technology companies. Bond ETFs track a specific bond index, such as the Bloomberg Barclays U.S. Aggregate Bond Index. If you are interested in investing in commodities, such as gold or oil, you have commodity ETFs. Currency ETFs focus on investment in foreign currencies.
ETF vs. Mutual Fund
ETFs are often compared to mutual funds, as they both offer investors a way to diversify their portfolios. However, there are some key differences between the two investment vehicles. Firstly, ETFs trade like stocks on an exchange, whereas mutual funds are bought and sold at the end of the trading day at the net asset value (NAV) price. This means that ETFs can be bought and sold throughout the day at market prices, whereas mutual funds are bought or sold at the end of the day at the NAV.
Secondly, ETFs typically have lower expense ratios compared to mutual funds. This is because ETFs are passively managed, meaning they track an index, while mutual funds are actively managed, meaning they have a team of managers who make investment decisions.
Benefits of ETFs
ETFs offer several benefits to investors. Firstly, they provide a low-cost way to gain exposure to a diversified portfolio of securities. This is because ETFs are passively managed, and their fees are typically lower than those of actively managed mutual funds.
Also, ETFs give you flexibility. They can be bought and sold throughout the trading day, and investors can use limit orders, stop orders, and other trading strategies to manage their investments. ETFs can also be used for short-term trading or as a long-term investment.
Additionally, ETFs offer transparency. Unlike mutual funds, which only disclose their holdings quarterly, ETFs disclose their holdings daily. This allows investors to see exactly what securities they are investing in and the percentage of the ETF’s assets that are allocated to each security.
Finally, ETFs offer tax efficiency. Because they are passively managed, they typically generate fewer capital gains distributions than actively managed mutual funds. This can result in lower tax liabilities for investors.
Are ETFs right for you?
ETFs can be a great way to invest in a variety of different market assets. However, for some investors, ETFs may not be the best option. It really depends on what type of investment strategy you are adopting, and the wealth management goals you have for yourself. Your financial advisor can analyze your situation and help you decide if ETFs make sense for your portfolio.