ETFs’ basics explained
ETFs are baskets of securities that trade like stocks. They track a major index, such as the Dow Jones, Nasdaq-100 and S&P 500.
There seems to be an ETF for everything, so you name it, and there’s likely an ETF for it. For example, ETFs can be based on different sectors, categories, and assets classes. Asset classes are the most common, and include stocks and bonds.
It is estimated that there were more than 1,600 ETFs in the market as of the end of 2016.
When you buy ETF shares, you are buying shares of a portfolio. Again, ETFs trade like stocks. Think of them as tracking an underlying asset, such as shares of stock, bonds, and even gold bars.
ETF.com summarizes these funds as low-cost offerings that access virtually every corner of the market.
“ETFs allow investors big and small to build institutional-caliber portfolios with lower costs and better transparency than ever before,” according to ETF.com.
ETFs can be easily tailored to meet the individual needs of the investor. This is one of the reasons ETFs can be an investor’s delight – they make diversification easy. Depending on the investor’s time horizon, these assets classes can be further divvyed up to include riskier securities so that any losses that may result can be recouped over the long term.
Take for example, the SPDR Barclays High Yield Bond fund (JNK). In it are various high-yield corporate bonds that can earn the investor an income stream that is highly diversified. That higher yield comes with the increase risks that the corporation could have trouble repaying the debt, or even defaulting.
One thing to remember about ETFs is that although they provide diversity, they are just as much susceptible to market volatility as are individual stocks.
ETFs to mitigate risks
In addition to ETFs including an impressive list of asset classes, they can also include securities from specific sectors, industries, and countries. In many cases, investors may take on the additional risks of investing in certain areas for the potential of greater returns.
ETFs could make it easier to handle risks associated with such investments because they can be tailored to include assets that could act as hedgers. Let’s say an industry has been very volatile, or faces headwinds that could put downward pressure the stocks in it.
The potential risks may cause leery investors to shy away, and miss an opportunity to add diversity to their portfolio. Well, ETFs could provide an option. The investor could short an industry-sector ETF, or buy an ETF that shorts the industry, points out Fidelity Investments.
Other strategies can include ETFs that focus on a mix of stocks, say fewer than 10. The fund could include large cap and small cap stops. It can even include emerging markets investments. This kind of diversification allows for the investor to have varying exposure without taking on as much risk.
If taxes are a concern, placing ETFs in tax-sheltered retirement accounts, such as a traditional IRA, should be considered. This allows the investor to avoid paying taxes on capital gains or investment income that accrues until a withdrawal is made.
Why ETFs instead of mutual funds
ETFs are akin to mutual funds in that they consist of a basket of securities. That’s just about where their similarities end. The most important difference from an investor’s standpoint relates to the costs to investors.
Both ETFs and mutual funds come with a host of fees, however they are usually more for mutual funds. That’s because of the loads that are typical for mutual funds, but not for ETFs.
Another difference relates to how they trade. ETFs trade on a stock exchange, so their prices fluctuate throughout a trading day. Mutual funds, on the other hand, have shares that are priced once a day after the market closes.
Investors who’ve added ETFs to their investment strategies have found them to be key to diversifying their portfolios.
Before you jump into the fray, seek out a professional to gain a better understanding of your options when it comes to ETFs.
ETFs can give investors the chance to make investment decisions when it’s best for them. Also, placing orders can be facilitated easily. Investors who choose brokers may also enjoy being able to purchase ETFs on margin from the broker they select.
Remember, whatever decision you make on investing in ETFs, seek the advice of a professional. Be prepared to discuss your long-term goals, as well as your risk tolerance to help make the best decisions.