ETFs: A Flexible, Low-Cost Investment

Whether it was on the business news or in your personal research, you’ve probably heard about exchange-traded funds (ETFs). For many investors, ETFs offer a flexible and low-cost way to diversify investments and I use them in my clients’ portfolios when appropriate.

What Are ETFs

ETFs are investment companies that hold a “basket” of securities typically consisting of the stocks or bonds that make up a particular market index. ETFs usually track indexes that focus on either a market as a whole or on specific industries, countries, or economic sectors.

In that way, they’re like index mutual funds. Unlike mutual funds—whose shares are valued at the end of the trading day—ETF shares trade on a securities exchange throughout the trading day, any time the market is open.

The History and Future of ETFs

As with other investments, ETFs carry risks, including market risk (the risk that their value may decline due to economic or other events affecting the overall market) and interest rate risk (the risk that changes in interest rates may lower bond prices). ETFs have been around in the U.S. since 1993 and have experienced ups and downs—in their use as well as their effectiveness—during that time.

Use of ETFs as an investment option is currently on an upswing and many investors predict that the future will see an increase in both actively managed ETFs and use of ETFs for retirement funds.

Benefits of ETFs

For many of my clients, ETFs are a valuable addition to a well-rounded portfolio, providing a low-cost, tax-friendly, and flexible investment option.  ETFs usually don’t require a minimum investment and fees and annual expenses are typically low since the fund is passively managed and generally mirrors the index it tracks.

Like stocks, ETF shares are sold to other ETF investors, so the fund doesn’t have to sell securities to meet redemptions. This limits taxable distributions of capital gains. (However, when ETF investors sell their shares any gains from the sale are treated as capital gains.

ETF shares are available in a variety of market sectors, so they offer a good way to reflect your personal interests and investment strategies in your portfolio. Many types of ETFs are available:

• Broad-based ETFs track indexes for small, mid-size, and large U.S. company stocks, growth stocks and value stocks.
• Sector ETFs focus on specific industries, such as technology and pharmaceuticals, and are less diversified than broad-based funds.
• International ETFs track indexes for individual foreign countries and world regions, as well as broad-based global indexes.
• Fixed-income ETFs track corporate and Treasury bond indexes.

In addition, ETFs can be weighted either by market capitalization (meaning larger companies are more heavily represented in the index) or can be weighted equally (meaning all funds carry the same weight). Typically, I recommend market cap ETFs because they include a greater number of large, established companies.

The Bottom Line on ETFs

ETFs can be another way to add diversification to your investment portfolio through a targeted investment in a specific industry or sector.