Exchange traded funds (ETFs) are a popular investment vehicle. Investors who take advantage of ETFs as part of their investing strategy reap many benefits. Those benefits helped propel the total ETF assets under management to more than $5 trillion in 2020.
If you are looking to diversify your investments, hedge your risk, or gain exposure to a certain industry or market, then ETFs may be the perfect asset for your portfolio. Here are some more details on why so many investors love ETFs.
ETFs replicate the holdings of indexes. Therefore, ETFs can follow specific industries, regions, or any other sector that an index can track. However, traditional index investing requires investors to individually purchase every security held in an index's basket of stocks.
ETF investing essentially provides the same diverse group of holdings with a single transaction. You can think of each ETF share as its own mini-portfolio—a basket of partial stock shares. This simplifies the purchasing process, so investors don't have to place dozens of orders and decide what a fair price would be for each of those orders.
ETFs simplify the buying process, but not at the sacrifice of liquidity. Like stocks, ETFs trade throughout market hours. They trade frequently, as well. The SPDR S&P 500 ETF (SPY) is the most popular ETF by volume, and more than 100 million shares exchange hands on an average trading day. This liquidity allows investors to jump into or out of positions as frequently as they please.
ETFs can also be sold short or on margin, and prices are continuously updated during the trading day. In other words, ETFs trade just like equities on the stock market, despite how much more diversity they provide for investors.
It's easy for investors to save money with ETFs. Since there is only one transaction per trade, you'll avoid the accumulation of commission fees that can occur when you're adding a basket of stocks to your portfolio. Also, managing fees tend to be lower for ETFs than they are for regular mutual funds, and you'll avoid load fees.
If you've researched ETFs at all, you've probably seen them referred to as a "tax-friendly" investment. When compared to traditional mutual funds, this is generally true. Mutual funds are typically more actively traded than ETFs, and each trade invites an opportunity for capital gains taxes. Mutual fund capital gains taxes typically accumulate and are imposed on fund holders annually.
In the case of ETFs, on the other hand, capital gains are not realized until the assets are sold. That means an investor can effectively choose when to impose ETF taxes on themself. However, investors will still pay taxes on ETF dividends as they're distributed.
For those who like to use options, swaps, and futures contracts as tools for risk management, they have that option with ETFs. Whether you want to hedge your ETFs with calls and puts or trade ETF volatility with option straddles, you will likely find an ETF with that flexibility.
Also, be aware that sometimes options and futures are included in an ETF's holdings. Derivatives aren't usually included in passive index ETFs, but they are commonplace in leveraged and inverse ETFs. It's always a good idea to check an ETF's holdings before adding it to your portfolio, so you can fully understand the impact the ETF will have on your trading strategy and risk exposure.
The financial entities behind actively traded ETFs are required to publish the list of assets in the fund daily. Similar mutual funds don't have the same requirements, so investors know less about the products in their portfolios.
While some ETFs are actively traded, many are passively managed. Passive ETFs replicate a particular index or benchmark without seeking to outperform it (although that can happen on occasion). Therefore, only minor adjustments are needed for the ETF, as opposed to an aggressively managed mutual fund that seeks to outperform its underlying benchmark. This difference results in relatively lower risk and fewer management fees for ETFs.
Most ETFs distribute dividends as a stock would. You'll get a quarterly dividend payment dropped into your brokerage account. In the case of traditional mutual funds, the time frames may vary. Many mutual funds distribute dividends annually, rather than quarterly.
ETFs are simple in structure and easy to understand (except for advanced products like leveraged and inverse ETFs). The best investors fully understand their investment products, and simple products like ETFs lower the barriers to understanding the investment. So if you are looking to invest in a certain industry or want to emulate the returns on a particular index, you are only one trade away from getting started with ETFs.
There are many advantages to including ETFs in your investment portfolio. While mutual funds, equities, derivatives, and indexes are all solid investments, ETFs are a financial weapon that should be part of your investing arsenal.