An ETF, or exchange traded fund, is a collection of securities that track an index or industry. These securities can be made up of stocks, bonds, commodities, or a mix. ETFs are traded on an exchange and the price can fluctuate throughout the trading day, just like stocks.
When asked, “What is an ETF?” many investors will answer by mentioning the exchange traded fund’s ability to hold an array of investments while tracking an index or industry. ETFs are desirable to many investors due to a myriad of reasons that we look at below.
What is an ETF? A diverse investment opportunity for the right investors
ETFs hold multiple assets, unlike a stock which holds only one asset. This is one way ETFs create a greater level of diversification than individual stocks. Many investors strive to create a diversified portfolio so they can lower their risk potential while creating a better chance for higher returns over long periods of time. A diverse portfolio requires less monitoring while providing more stability. Investing in the right ETFs helps build a diversified portfolio because ETFs themselves are made of a collection of securities.
Buying ETFs can lead to lower costs
ETFs provide a lower cost in two main ways. First, the cost of an ETF is always less than if an investor bought all of the same stocks individually. Fewer transactions means few commissions that need to be paid to a stock broker for each trade.
Second, traditional ETFs have a lower expense rate because they track an index, making it a less time-intensive investment. Traditional ETFs are often known as being passively managed because of this ability to track an index.
Understand traditional ETFs and new ETFs
As mentioned above, traditional ETFs come with lower expenses and are passively managed. New ETFs are often actively managed, leading to higher fees. These higher fees could make the ETF less attractive to the buyer, so it is always important to recognize the expense ratio to determine if the new ETF is worth holding. If the costs outweigh the rate of return, then that new ETF may become a problematic investment.
Recognize the benefit of ETFs over mutual funds
Both mutual funds and ETFs involve a collection of investment product options, but there are still some differences between the two. For instance, mutual funds are not traded on an exchange. Instead, mutual fund transactions are made directly with the fund. Mutual funds can only be traded once each day and that is after the market closes for the day.
Mutual funds also have minimum purchase amounts, often around $1,000, whereas there is no minimum amount associated with ETF investing. Mutual funds are actively managed, whereas only some forms of new ETFs involve the same active management. Due to this, the fees behind mutual funds are typically higher than those of ETFs.
Mutual funds tend to incur regular capital gains due to yearly distributions. Traditional ETFs do not have this same issue as a result of low turnover within its holdings.
ETFs and dividend payments
ETFs can yield dividend payments for investors. Due to this and the myriad of other reasons listed above, consider ETF investments if you are interested in lower management costs, less risk, and greater diversification than individual stocks.
Have you ever invested in ETFs? What has your experience been like?