Exchange-traded funds (ETFs) are a popular way to build a simple and low-cost diverse portfolio. There are many investing benefits to ETFs, which is why they’ve grown in popularity both for DIY investors and for more traditional money managers.
ETFs may be a good investment strategy if you’re looking to invest a lump of money for a long-term investment goal. Let’s understand how ETFs work, how they get traded, and their advantages and disadvantages.
What Are the Benefits of ETFs?
Exchange-traded funds (ETFs) have become increasingly popular in recent years, especially with the rise of online brokerages allowing people to buy and sell them quickly.
As an investment tool, ETFs have become popular: there were more than 8,500 ETFs in the world with more than $10 trillion in assets under management (AUM) at the end of 2021. Meanwhile, in the U.S., there were about 3,000 ETFs that had approximately $5.9 trillion AUM as of September 2022.
Easy to Trade
ETFs are traded on stock exchanges and can be bought and sold throughout the day, like individual stocks. The market determines the price for a share of an ETF and changes throughout the day. This means investors can easily buy and sell ETFs, making them a convenient investment option.
An additional benefit of an ETF is that you don’t need a lot of money to invest in many different things. One share of an ETF offers investors a way to diversify their portfolio by investing in a basket of assets, such as stocks, bonds, or commodities, rather than just a single asset. This can help to reduce the overall risk of an investment portfolio.
Accessible Across Markets
There is also a range of ETFs on the market now: stocks, bonds, commodities, real estate, and hybrids that offer a mix. ETFs also vary in how they target certain assets — aggressively or defensively, specific to one asset class or broad. So investors should be able to find what they want and build a diverse portfolio.
Most ETFs are passively managed and track a benchmark index, meaning portfolio managers don’t actively manage the fund to try to beat the market or an index. Passive investing, as opposed to active investing, may be more cost-effective because there is less overhead and fewer investment fees.
Because there is less overhead, ETFs generally charge investors a lower operating expense ratio than actively managed mutual funds. The operating expense ratio is the annual rate the fund charges to pay for portfolio management, administration, and other costs.
There are other costs investors need to consider, like commissions for trades and a bid/ask spread.
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ETFs tend to be more tax efficient than mutual funds because they typically generate fewer capital gains and capital gains taxes. This is because passively managed ETFs tend to have lower turnover than actively managed mutual funds, which means they sell fewer assets and, thus, result in fewer capital gains.
ETFs generally disclose their holdings daily, so investors can see exactly what assets the ETF holds. This can be helpful for investors who want to know what they are investing in.
ETFs can be used in various investment strategies, including as part of a long-term buy-and-hold strategy or as a short-term trading tool. This makes them a flexible investment option for a wide range of investors.
Moreover, investors can trade thematic ETFs — funds focusing on a specific trend or niche industry, like robotics, artificial intelligence, or gender equality. However, there are pros and cons to thematic ETFs. While they allow investors to make more targeted investments, the shares of these funds can be volatile. Because they’re so focused, these ETFs may also diminish the most important benefit of ETFs: broad, diverse exposure.
Disadvantages of ETFs
While ETFs offer many benefits to investors, there are also some potential disadvantages to consider. These disadvantages include the following:
Lack of Personalization
Because ETFs are not actively managed, they do not consider an investor’s specific financial goals or risk tolerance. A lack of personalization means that ETF investors may be unable to tailor their investment portfolio to their particular financial needs.
ETFs are usually designed to track the performance of a particular index or basket of assets. However, the performance of the ETF may not precisely match the performance of the underlying index due to various factors, such as the fund’s expenses or the timing of when it buys and sells assets. This is known as a tracking error.
Short-Term Trading Costs
ETFs can be traded on the market throughout the day, making them attractive to short-term traders. However, the commission costs of trading ETFs can add up over time, which can eat into investment returns.
While many ETFs are available, the range of options may be limited compared to other investment vehicles, such as mutual funds. Thus, investors may be unable to find an ETF that perfectly matches their investment needs.
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Certain ETFs may use financial instruments, such as futures contracts or swaps, to gain exposure to specific assets. These instruments carry counterparty risk, which means that there is a risk that the counterparty will not fulfill its obligations under the contract. This can expose ETF investors to additional risks.
Some ETFs use complex investment strategies, such as leveraged or inverse ETFs, which can be difficult for some investors to understand. Complex investing strategies can make it challenging for investors to fully understand the risks and potential returns of these types of ETFs.
ETFs, like all investments, are subject to market risk, meaning the value of an ETF can go up or down depending on the performance of the underlying assets.
What to Consider When Investing in ETFs
When investing in ETFs, it is essential to consider the following factors:
• Investment objective: Determine your investment goals and how ETFs fit into your overall investment strategy. This can help you choose an ETF that aligns with your financial goals and risk tolerance.
• Asset class: Consider which asset classes you want to invest in and whether an ETF that tracks those assets is available. For example, if you want to invest in large-cap domestic stocks, look for an ETF that tracks a particular large-cap domestic stock index.
• Diversification: ETFs offer a way to diversify your investment portfolio by investing in a basket of assets rather than just a single asset. Consider the level of diversification an ETF offers and whether it aligns with your investment goals.
• Expenses: ETFs typically have lower fees than mutual funds because they are not actively managed. However, it is still important to compare the expenses of different ETFs to ensure you are getting the best value for your money.
• Tax considerations: ETFs tend to be more tax efficient than mutual funds because they generate fewer capital gains. However, it is still important to consider the tax implications of investing in an ETF and whether it aligns with your overall financial plan.
Investing With SoFi
ETFs are becoming increasingly more popular, with some being more targeted in focus than others. So, being aware of an ETF’s investments can be important for an investor who chooses to put dollars into this financial vehicle.
For those who are ready to dive into ETF investing on their own, opening a SoFi Invest® online brokerage account may be a good option. With SoFi, you can trade ETFs, as well as stocks, IPOs, fractional shares, and more, with no commissions (though investors are responsible for paying operating expense ratios when investing in ETFs). And we know that when starting out investing, it can help to get professional guidance. So SoFi offers its members complimentary access to financial planners who can give advice on risk tolerance and investment horizons.
What is the benefit of investing in an exchange-traded fund?
Exchange-traded funds (ETFs) offer investors a convenient and cost-effective way to diversify their portfolios by investing in a basket of assets. ETFs are also typically more tax efficient than mutual funds and offer investors the ability to buy and sell their shares on a stock exchange.
Are ETFs a good investment?
Depending on their investment goals and risk tolerance, ETFs may be a good investment for some investors. ETFs offer a convenient and cost-effective way to diversify a portfolio and provide access to a wide range of asset classes. However, it is important for investors to consider the specific ETF they are considering and how it fits into their overall investment plan.
Why are ETFs better than stocks?
For some investors, ETFs may be a better investment option than individual stocks because they offer diversification by investing in a basket of assets rather than just a single stock.
Is an ETF better than a mutual fund?
Whether an ETF is better than a mutual fund depends on the specific circumstances of the investor and their investment goals. ETFs tend to have lower fees than mutual funds because they are not actively managed and may also be more tax efficient due to their lower turnover. However, mutual funds offer a more comprehensive range of investment options and may be more suitable for some investors.
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Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected]. Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.