In the investing world, exchange traded funds (ETFs) are the latest and greatest. Although they’ve been available for more than 10 years, it wasn’t until recently that the popularity of ETFs took off.
ETFs are a group of stocks that trade on the stock exchanges as if they are one stock. Generally in the past they have tracked a particular index such as the Dow Jones Industrial Average or the NASDAQ-100. Recently, however, they are forming ETFs that have a particular characteristic in common: they invest in a particular region or sector of the market, or have a certain market capitalization.
Exchange traded funds have many advantages over mutual funds. They can have a low cost of obtaining since you are paying a commission just like when you purchase individual stocks. If you use a discount brokerage, you can buy for very little money. The regular maintenance fees for an ETF are also small when compared to managed mutual funds, and sometimes lower than index mutual funds.
Because ETFs trade like stock they have liquidity. With a simple phone call you can buy or sell. ETF exchange traded funds are priced every 15 seconds and trade continually throughout the day. This is not like mutual funds because mutual funds are only bought and sold at the end of the day. Since the ETF will be held in a brokerage account, it is easily traded.
Tracking an index means less selling within the fund. This is a fund that is very tax efficient. ETFs rarely declare a capital gain. This means you determine when the taxes will be paid on the gain by choosing when you will sell.
Index and actively managed funds retain a portion of their investable assets in cash. This is used to pay someone who is selling their fund. Since ETFs trade like individual stocks on the open market there is no need to retain a portion in cash.
There is zero room for style drift in an exchange traded fund. In a managed fund, they might say it’s a large cap fund, but in reality they might chase performance by investing in small or mid cap funds. Exchange traded funds are required to keep a 99% correlation with the index or collection of stocks that it represents.
Regarding ETF trading strategies, because ETFs trade like individual stocks you have the additional features of stock. ETFs can be sold short or on margin. They can have limit, buy and stop loss orders for buying and selling. Put and call options can be purchased and sold using ETFs.
There are of course disadvantages to ETFs as well. They are not ideal for dollar cost averaging. If you have to pay a $10.00 fee each month when you make that $50 or $100 investment it can be difficult to make up that fee.
With the popularity of ETFs, you have to be careful as to what the fund is using as its foundation of stocks. Sometimes it can be such a narrow focus that you really are not achieving diversification.
Due to the ease of trading you can get caught up in riskier strategies than you want. Short term trading and market timing can result in significant losses. Puts and calls, or buying on margin when buying and selling ETFs, is riskier than buying and holding.
ETFs make sense under the right circumstances. You can use a broad index ETF as a core holding. This can be supplemented with targeted ETFs to provide weighting in a particular sector, region or type of market capitalization. As always, be smart and invest slowly.