Diversification is key to your potential long-term success in securities markets. ETFs generally can give investors access to diversification at lower costs and enhanced tax efficiency.
An ETF (Exchange-Traded Fund) is a type of security made up of a bundle of assets that track a particular securities index, commodity, bond type, or a grouping of assets. They're bought and sold on securities exchanges throughout a trading day like stocks. The price of an ETF is based on market supply and demand, and often trade at a price higher or lower than the ETF's Net Asset Value (NAV). Depending on your goals, there are several types of ETFs that could help you generate income, grow your investment dollars, or offset risk in your portfolio.
ETFs are either passively or actively managed. Generally, the goal of passive ETFs is to duplicate the performance of a broader index, such as the S&P 500 or a specific sector. By contrast, managers of actively managed ETFs pursue better-than-market returns. Here are some notable advantages and disadvantages of holding ETFs in your portfolio:
ETFs have many types of sectors, styles, industries, even countries, which facilitates investing in just about any market segment you want. However, some sectors could limit you to a narrow group of equities in the market index.
ETFs are bought and sold throughout the trading day based on the price at that moment. On the other hand, ETFs could have low dollar volumes (thinly traded) and you may have a hard time finding a buyer in the market.
With an ETF, you'll only realize capital gains when you sell shares, but mutual funds pass the gains on to you in the year the fund realizes them for as long as you own shares.
ETFs don't have some of the costs associated with mutual funds, such as 12b–1 fees or sales loads. But if you compare ETFs to investing in a specific stock, then costs could be higher as stocks do not have a management fee.
Questions about ETFs? We've got answers.
Aside from the way an ETF is managed (active or passive), there are several categories of investments held within the ETF. Here are the most common types:
Stock ETFs:
Usually meant for long-term growth, stock ETFs are typically less risky than individual stocks because of the built-in diversification. However, they are riskier than some other ETF types, such as bond ETFs.
Bond ETFs:
Unlike individual bonds, bond ETFs can hold several bonds with staggered maturity dates, so as bonds mature and new ones are purchased, they can keep a steadier stream of interest income.
Commodity ETFs:
This type of ETF bundles raw goods (e.g., gold, orange juice, energy, wheat, livestock, etc.) into a single investment. It's important to know how a specific fund works as it can have varying tax implications and risk levels. Here are some things to consider: will you have direct ownership of a commodity, or own equity in companies that produce, transport and store these goods, or does the ETF contain futures contracts? Understanding these will help you figure out what type of commodity ETF could be right for your portfolio.
Sector ETFs:
Each of the 11 sectors of the U.S. stock market are made up of companies that operate within that sector (e.g., technology, health care, financial, or industrial). Some sectors tend to perform better during expansion periods, others during times of contraction, so they can be especially useful if you want to align your investing strategy to business cycles. Often, this type of ETF carries higher risk than broad-market ETFs.
Foreign Market ETFs:
Foreign stocks are widely used for building a diverse portfolio (along with U.S. stocks and bonds) and are an easy way to hold foreign investments in individual or groups of countries.
Thematic ETFs:
In addition to the common market indexes, there are ETFs that track investing themes, such as artificial intelligence, highest dividends, or founder-run companies. These ETFs may hold stocks of all asset classes in any part of the world, so long as they align with an overarching theme.
Factor ETFs:
Similar to thematic ETFs, Factor ETFs use certain valuation methods or technical analysis to choose stocks with certain fundamental characteristics. Typical Factor ETFs include those that target growth stocks, value stocks, dividend payers, high-yield corporate debt, or momentum stocks.
Floating Rate ETFs:
These are fixed income funds that primarily hold floating rate loans, which are loans typically made by banks to companies rated below investment grade by rating agencies like Moody's or Standard & Poor's. Floating Rate ETFs could produce higher yields than an investment grade Bond ETF and might give you protection from rising interest rates. In exchange for this higher yield potential, the ETF price could have increased volatility and comes with higher risk.
There are several things that differentiate an ETF from a mutual fund, including:
Investment minimums:
ETFs can be purchased by the share, so the investment minimum can be low. On the other hand, mutual funds may require a minimum investment that can be much higher.
Cost and pricing transparency:
The fees and expenses of ETFs tend to be lower than those of mutual funds, but that's not always the case. Since ETFs are traded on an exchange like stocks, the price fluctuates throughout the trading day, so you can trade them anytime during market hours and know upfront what you're paying. With mutual funds, you can still place buy and sell orders when the market is open, but it won't be priced until after the market closes when NAV is calculated.
Tax implications:
ETFs typically can be more tax efficient because you only realize capital gains when you sell shares, whereas mutual funds pass the gains on to you in the year the fund realizes them for as long as you own shares.
Because there are many asset classes (equities, bonds, commodities, currencies, etc.), several market sectors, as well as varying investment objectives, there isn't a singular expectation of performance. ETF performance is generally linked to a benchmark index, meaning that they are often designed to mirror, but not outperform, that index.
Talk to an advisor about how ETFs can help you reach your goals. Get matched now.
Because ETFs are made up of a range of stocks, bonds, or a mixture of both, they do provide more diversification than owning an individual stock or an individual bond. But not all ETFs are equally diversified. When most people talk about diversification, what they really mean is spreading out your investment dollars across different asset classes to help reduce risk. Find out how to diversify your portfolio with our guide.
In general, yes. ETFs can be a smart way for almost any kind of investor, from professional money managers to people just starting out, to easily build a diverse portfolio. ETFs are considered good investments for beginners because they're easy to understand compared to other types of investments, typically have a low cost, you can start with a smaller amount of money, there are lots of options to choose from depending on your goals, and more. Check out our guide to investing for beginners to learn more.
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