Diversification is an important component of long-term success in markets, and perhaps no financial product has helped everyday investors and major institutions alike easily reap the benefits of diversification like exchange-traded funds (ETFs).

So, what is an ETF and why are they so popular these days?

What is an ETF?

ETFs are essentially a hybrid of stocks and mutual funds. Like mutual funds, ETFs allow investors to buy an entire basket of stocks, bonds, commodities — just about any asset these days — in a single transaction. But like a stock, ETFs can be instantly bought and sold by investors throughout the day during normal trading hours, and their prices fluctuate instantly in line with demand. Mutual fund orders, on the other hand, are executed once, at the end of the day, and all trades are handled by the respective fund managers.

Therefore, ETFs are lauded for their liquidity, ease of trading and instant diversification. You can also get ETFs that track just about anything you’d like. There are ETFs that hold every single stock in the S&P 500, the entire U.S. stock market, or a basket of Treasury bonds. Some ETFs focus on a single sector, such as Industrials, and there are ETFs that hold stocks of companies based in Europe or in Emerging Markets.

A brief history of ETFs

Technically, the first ETF was launched in Canada back in 1990, although a typical retail investor wouldn’t recognize that product. Those early relatives were largely used by large, institutional investors to purchase and sell pooled assets. The first ETF that retail investors would recognize was the SPDR S&P 500 Trust ETF (ticker: SPY) launched in 1993 here in the U.S. It first traded on Jan. 29 of that year and amassed $461 million in assets. Today, SPY, nicknamed the “spider”, has more than $368 billion in assets and is the largest ETF on the market.

SPY ushered in a vibrant industry of ETFs, and the iterations and types of ETFs have exploded. There are now thousands of ETFs with a combined $9 trillion held within them, according to Morningstar research.

How ETFs work

ETF providers outline the rules, or investing philosophy, that an ETF will adhere to. A market cap-weighted ETF that uses the S&P 500 (or a host of others) as its benchmark will buy every stock in the S&P 500, proportional to its weighting in the index. If Apple represents 6 percent of the S&P 500 market cap, Apple will represent 6 percent of the ETFs holdings. It may also deploy a method known as optimization, or a representative sample of the index based on correlations, exposure, and risk.

The ETF’s fund provider owns the underlying assets in the fund, while ETF investors technically own a share of that fund. The price of an ETF generally tracks the underlying value of the fund (it isn’t always exact), but the fund’s price can also be affected by market demand for the ETF. When more money flows into an ETF, its price will rise (demand rises) and the fund provider will then buy more of the underlying assets in proportion to the amount of money that’s come in the door. The same is true when investors sell an ETF.

Why ETFs are useful in a portfolio

Liquidity

Popular ETFs tend to have plenty of market participants buying and selling, which makes it easy for you or an advisor to rebalance your portfolio or dynamically overweight or underweight certain assets as part of a long-term investing strategy.

Instant diversification

Buying one share in an ETF can provide access to thousands of stocks, bonds etc. in a single transaction. This is beneficial for young investors just getting started, or experienced investors looking to plug a hole in a portfolio (gain exposure to municipal bonds or international markets). Northwestern Mutual portfolio managers and advisors often use ETFs to help their clients diversify their portfolios as well.

Low cost, low effort

Fees for ETFs tend to be lower than mutual funds, although that’s not always the case. And, it’s easier and more cost-effective than buying the assets individually — particularly for more complex asset classes such as bonds or commodities.

ETF terms to know

Passive vs. active management

Passive ETFs are essentially operated on autopilot. They simply follow a set of rules or a benchmark, such as the S&P or NASDAQ, and underlying assets are rebalanced to reflect that index. Active ETFs have a human fund manager at the helm making decisions about what assets, and in what proportion, the fund should hold. These funds will have an overarching philosophy, but fund managers have more leeway to buy and sell using their expertise. Typically, an actively managed ETF will have higher fees than passive funds.

Prospectus

Every ETF has a prospectus, or a comprehensive document that outlines the fund’s strategy, performance, fees, risks, the fund’s owner, and other important information. It’s not exactly a thrilling read, but worthwhile for investors doing their due diligence. Make sure you read the prospectus carefully before deciding to purchase any investment.

Net expense ratio

This, in a nutshell, is the annual fee a fund manager charges to offer the ETF. Fees range from as low as 0.04 percent to a few percentage points.

Tracking error

This describes how closely an ETF follows its intended benchmark. A high tracking error indicates a fund is diverging from the benchmark and may be worth a deeper dive as to why. Northwestern Mutual’s investment team looks closely at this metric when researching funds to include in client portfolios.

Discount/premium to NAV

ETFs don’t always match the value of their underlying assets 1 to 1. Sometimes, the share price (multiplied by total shares outstanding) is lower than the value of its underlying assets. When this is the case, the ETF is said to be trading at a discount to NAV. When the price is higher than the underlying assets, the ETF is trading at a premium to NAV.

Net assets

This is the combined value of all assets held in the ETF, but it’s not to be confused with the ETF’s price.

Net flows

This measures how much money has flowed into an ETF and is measured on a daily, weekly or monthly basis.

Thematic ETF

In addition to the common market indexes, there are ETFs that track investing themes, such as artificial intelligence, “dogs of the DOW”, founder-run companies — the list goes on. 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 ETF

Similar to thematic ETFs, factor ETFs use certain valuation methods or technical analysis to include stocks with certain fundamental characteristics. Typical factor ETFs include those that target growth stocks, value stocks, dividend payers, high-yield corporate debt, momentum stocks, quality.

ETFs are tools, not a plan

While ETFs offer certain benefits for investors, they’re simple tools. But tools alone don’t build a house — it requires a plan and skilled craftsmen to do it. While some investors are financially handy, others may benefit by working with a financial advisor who knows how to use a variety of financial tools to get you where you want to be. They’ll do the heavy lifting and build a plan that may incorporate ETFs so you can live your life without added financial stress.

Exchange traded funds (ETFs) have risks and trade similar to stocks. Shares of ETFs are bought and sold in the market at a market price, as a result, they may trade at a premium or discount to the fund's actual net asset value. Investors selling ETF shares in the market may lose money including the original amount invested.

No investment strategy can guarantee a profit or protect against loss. All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss in a down market. This is for information purposes only and not a solicitation to purchase any security.

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