You’ve probably heard about the virtues of ETFs and how they are eating mutual funds’ lunch. Are they really that great? Should you put ETFs in your portfolio? Let’s take a look
What Are ETFs?
ETF stands for “Exchange Traded Fund”. They are very similar to mutual funds in that they pool money together and buy stocks and/or bonds for investors. If you have money and you want to buy an ETF index fund you can do so very easily at just about any of the big brokerage firms.
The big difference between ETFs and most mutual funds is that ETFs are normally very passive and inexpensive; the manager usually buys the same stocks or bonds that are in an index and holds on to them until the index itself changes. That reduces trading and that translates into lower costs and lower tax exposure for investors.
Another distinguisher is that ETFs can be bought and sold during the day just like stocks. This added liquidity coupled with the lower costs have made them the darling of the investment world for the last decade.
Are ETFs Better Than Mutual Funds?
This is an important question to ask but there really isn’t one right answer. It largely depends on your objectives and your investment strategy. If you are a buy and hold investor, ETFs could work for you. That’s because over a very long period of time, most mutual funds don’t consistently beat the market (or index). So if you are going to buy a fund and hold on to it forever, the cheaper ETF index fund could be a very smart way to go.
But let’s say you don’t want to buy and hold. You have a concern that when the market tanks, buying and holding could lead to serious losses. Let’s assume you use an investment approach that shifts money around depending on market conditions and which funds are performing best right now. In that case, you should be open to investing in either ETFs or mutual funds. If a fund is doing better than an ETF at a point in time, there would be no reason to exclude funds from your portfolio using a dynamic investment style like that. Remember, performance is always reported net of fees so if you select funds based on performance, the costs just don’t matter.
How to Narrow Down Your Search
I mentioned above that many ETFs mimic a market index – but there are hundreds of indexes available and thousands of ETFs. Some ETFs are structured around broad indexes like the S&P 500 and others are very narrow. Some offer capital appreciation potential, others offer dividends and interest and still others offer both. That’s because some ETFs only buy stocks, others buy only bonds (or preferred shares) and others offer a mix.
So in order to buy the right ETF for you, be clear on your investment objectives first and then start shopping. I mentioned that most brokerage firms offer ETFs. Well, they usually also offer good filters to help their investors find the right ETF to. You can also look at ETF.com to get better acquainted with the choices.
How Risky Are ETFs?
Depending on which ETF you buy, the risk you take could be all over the board. Some ETFs even hold currencies and commodities which can be extremely risky. And to make matters even more complicated, there are even leveraged ETFs that do two or three times better (or worse) than the market. And there are inverse market ETFs as well. These funds go up when the market goes down. Headache.
As you can see, there are ETFs for just about everyone. They can be as simple as you like or they can be very sophisticated.
My suggestion is to first be clear on your financial objectives before you go shopping.
Do you invest using ETFs? How do you pick the right ones?