What Are Exchange-Traded Funds, And Should You Consider Them For Your Portfolio

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“It’s been over thirty years since Toronto Stock Market launched the first exchange-traded fund (ETF). Since that time, ETFs have gained popularity and are poised to take over the current mutual fund market.” John Ripley

What are ETFs, anyway?

Created to give individual investors more liquid and tax-efficient products than traditional mutual funds, ETFs were initially a more passive investment type. As their popularity has grown, actively managed funds with higher management fees have become quite popular. Actively managed ETFs look to outperform market indexes. Unlike mutual funds, exchange-traded funds are bought and sold much like company stocks. ETFs have ticker symbols, and you can obtain price data during the trading day. However, unlike company stocks, the number of outstanding ETF shares may change daily. This difference occurs because exchange-traded funds create shares continuously. Shares are also regularly redeemed. Using specific investment characteristics, you can sort ETFs into three major types of funds.

Passive funds look to replicate the performance of broader equity markets or, sometimes, a specific sector. They are currently the most popular form of ETF.

Smart-beta funds, on the other hand, use rules-bases systems to select investments for the fund portfolio. Smart Beta ETFs subscribe to a predetermined set of financial metrics. Smart-beta funds can be regarded as a hybrid since they use a mixture of both passive and active investment strategies to achieve their goals.

Actively managed ETFs have managers or teams of managers who make investment decisions based on the portfolio’s underlying allocation. The goal of an actively managed ETF is to outperform the benchmark index. Investment returns of actively managed ETFs will not mirror the underlying index.

The plus side of ETFs.

Investment experts say that ETFs are poised to replace mutual funds in many Americans’ investment portfolios over the next decade. Since the 2008 market crash, investors have already put well over $4 TRILLION into exchange-traded funds.

There many reasons for the shift to ETFs. For example, ETFs are:

More transparent than mutual funds. Investors like to know what’s going on behind the curtains of their investments. Since many ETFs are index-based, they must publish daily reports of their holdings.

Easier to trade. Nearly all traditional mutual funds restrict trading to the end of the day. ETFs allow buying selling at any time of the day.

Potentially more tax-efficient. Generally, ETFs will produce a lower level of capital gains distributions relative to actively managed mutual funds.

Often more cost-effective than mutual funds. With ETFs, you only have one transaction per trade. This approach allows an investor to avoid some of the commission fees associated with adding a whole basket of stocks to the portfolio. Most ETFs also have lower management fees, and there are no load fees to pay.

Easier to understand than many other investments. Warren Buffett advises people to never invest in things they don’t understand. Except for more exotic ETFs, such as inverse and leveraged, these funds are easy for the average investor to understand. Simply structured ETFs are generally much more accessible to ordinary investors.

Potential disadvantages of exchange-traded funds.

  • There can be tracking errors. ETFs have a reputation for tracking their underlying indexes very well. However, technical issues can sometimes occur, creating discrepancies in tracking.
  • ETF settlement dates are long. When you sell an ETF, the transaction does not settle until two days after the sales transaction. That means the funds from that transaction won’t be available for you to reinvest for two days.
  • You could have higher trading costs. If you like to invest small amounts of money more frequently, you may want to consider lower-cost alternatives to ETFs.
  • Capital gains tax issues. Different exchange-traded funds treat capital gains distributions differently. Some funds distribute capital gains shares directly to shareholders, which means the shareholders must pay capital gains tax. Many times, investors want to reinvest their distributions, which can mean more new broker fees. Most of the time, it works out better if the fund keeps the capital gains and invests them. The problem for investors is that you must keep track of all ETFs in your portfolio to avoid potential tax liability.

Before investing in an ETF, you must know how that fund treats capital gains distributions.

The bottom line. ETFs are purchased and sold likes stocks. They provide individual investors with less expensive options to achieve portfolio diversification. Funds are available for nearly any sector in which you wish to invest. ETFs encompass various investment styles, such as growth or value investing, and can help mitigate a portfolio’s volatility while providing additional income streams.

As ETFs have become more popular, funds have evolved to match various investment strategies. Using ETFs, individuals can now invest in asset classes that were somewhat difficult to access previously, such as real estate, bonds, and currencies. However, ETFs are not for everyone. They have potential downsides.  Investors should clearly understand both the risks and rewards of ETFs to make the best selections. If you are interested in ETFs, it’s wise to sit down with an experienced investment advisor or financial planner to discuss the pros and cons of adding exchange-traded funds to your portfolio.

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