Exchange-traded funds might be one of the most exciting investment vehicles available on the markets today, but ETFs are easy to misunderstand. However, despite their apparent complexity from the outside, they can be an integral part of a diversified portfolio when carefully considered. What is an exchange-traded fund, though, and how can you incorporate one or more of them into your investment strategy? Let’s review all the critical factors.
The Basics of Exchange Traded Funds
An ETF is not a single stock or an individual company, even though if you own a share of an ETF, you can trade it in many of the same ways as you could a regular stock. Instead, an ETF is a bundle of different investments wrapped into one. An ETF could hold cash, commodities, government bonds, and of course, stocks, too. Another distinguishing factor of the ETF is that each one “pegs” to a particular index.
Unlike mutual or hedge funds, which attract investors based on the experience of the fund’s portfolio manager, ETFs solely track to one standard, such as the S&P 500 or picks made by firms such as Vanguard. This is not always true, however. Aside from passive ETFs, the other types of ETFs include:
- Active ETFs, a recently-approved fund type that acts similarly to a mutual fund.
- Equity or commodity ETFs. Some ETFs focus specifically on stocks, while others may represent investments in commodities futures markets.
All types of funds require investors in the fund to pay some form of fee, based on the amount of cash you invest.
What are the Benefits of Investing in ETFs?
Why does anyone choose to invest in ETFs? According to some surveys, young investors overwhelmingly choose ETFs — and even established traders pay close attention to their performance. Several notable benefits make them an increasingly popular option. Here’s why:
- ETFs provide an instant path towards diversification. The long-term stability of ETFs makes them an attractive way to generate slow, steady returns.
- Most ETF holdings remain highly liquid due to frequent trading action, leaving investors an easy way to tap into liquidity when necessary.
- ETF shares are easy to acquire even for the average investor, and the associated fees are typically lower than mutual funds.
There are tax advantages to choosing an ETF, too. Unlike mutual funds, which may distribute gains among fund members and trigger an additional tax burden, ETFs use a unique management structure to delay reporting requirements for earnings. As a result, you, the individual investor, only owe taxes on your capital gains on ETF holdings when you close your position and sell the shares. This benefit makes them an ideal long-term and lower-risk holding depending on the fund.
The Final Word
Although ETFs have attributes that make them similar to mutual funds, and they trade quite similarly to regular stocks, it is clear they are their own unique type of security. ETFs can represent an excellent addition to a portfolio that minimizes long-term risk and generates an ideally steady return for some investors. Now that you know the basics, consider taking a closer look at ETFs that might align with your investment goals. From their tax treatment to their historical performance, there’s plenty of research to do to fuel a foray into ETFs.