Exchange-traded funds 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 D.I.Y. investors and for more traditional money managers.
If you’re looking to invest a lump of money for a long-term investment goal, then ETFs may be a good investment strategy. Let’s understand how ETFs work, how they get traded, and what their pros and cons are.
What Are ETFs?
An exchange-traded fund or ETF is a basket or a fund made up of many different investments or securities rolled into a single share. This allows an investor to easily access a broad range of different markets and investments.
That means things like stocks and bonds are pooled together into an ETF—and shares of the ETF are then offered to investors on the different stock exchanges. So buying one share gives you exposure that’s proportional to all the holdings in that fund. So if ETF X has 3% of its assets in Stock A and 4% in Stock B, an investor also gets that much exposure to Stocks A and B through their shares of that fund.
Typically, an ETF tracks a benchmark — meaning the fund aims to invest to match the returns of certain benchmarks. Market ETFs, for example, track a major index, like the S&P 500 or Nasdaq 100. There are also actively managed ETFs, but most ETFs are passively managed.
This might sound very similar to a mutual fund, because mutual funds and ETFs are pretty similar. In many ways, the mutual fund was the predecessor of the ETF. But there are some key differences. Mutual funds are traded only once per day, after the market closes, because of how they’re structured and regulated.
ETFs are traded on the exchange —hence the name “exchange-traded fund.” That means you can buy and sell ETFs any time of day. That flexibility is one of the benefits of ETF investing.
What Are the Benefits of ETFs?
ETFs have become more and more popular in recent years, especially with the rise of online brokerages allowing people to easily buy and sell them.
As an investment tool, ETFs have become so popular: there were roughly 7,600 ETFs in the world that shared about $7.7 trillion in assets at the end of 2020. Meanwhile, in the U.S in April 2021, there were about 2,300 ETFs that had about $6.2 trillion in assets under management or AUM.
Here are the benefits of ETFs for investors.
Quick Portfolio Diversification
The biggest benefit of an ETF is you don’t need a lot of money to invest in lots of different things. One share of an ETF gets you access to many different companies or bonds.
Accessible Across Markets
There are 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 not, specific to one asset class or broad. So investors should be able to find what they want and build a diverse portfolio.
Thematic ETFs are more narrow funds that focus 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 bets, 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.
Because most ETFs track against a benchmark index, they aren’t actively managed by financial managers trying to beat the market. Passive investing as opposed to active can make the former a more cost-effective style as it means there’s less overhead and fees.
ETFs are typically low-cost, with many charging less than 0.25% per year, although some brokerage firms may charge transaction fees for trades. There can be more hidden costs to ETFs too, such as the expense ratio and a bid/ask spread, which can add up.
Easy to Trade
As mentioned, the ability to trade ETFs throughout the day adds to their flexibility. Prices are determined by the market and change throughout the day.
Advantages of ETFs in Your Portfolio
If you want to start investing, then ETFs could be an option — depending on how actively you want to trade and what your financial goals are.
Instead of trying to build a basket of investments where you have to buy into each stock or asset, you might be able to buy into an ETF that covers a wide range of assets with just one transaction. It can give you more diversification for fewer fees.
If you’re planning to build an investment portfolio on your own, then ETFs have the potential to make it simpler. ETF advantages include having to buy one share of a fund to get exposure to a wide range of assets. First, determine what sort of portfolio asset allocation will help you meet your financial goals — that’s the make-up and mix of different asset classes.
Then, you may be able to select ETFs to match your desired investment make-up. It can be important to rebalance throughout the year to keep your portfolio at its desired make-up. There are certainly ways to get more complicated with ETFs — there are funds that allow you to replicate more complicated trading strategies, like shorting a stock and option trading.
Leveraged ETFs use derivatives in order to allow investors to make amplified bets on an index or sector. For instance, buying a leveraged ETF can give you 200% to an index. So if the index moves up 1% one day, the investor will see a 2% jump in the ETF.
Disadvantages of ETFs in Your Portfolio
When comparing the costs of investing in a particular stock with investing in ETFs, the costs may be higher for the ETFs if there are management fees charged.
Plus, one of the potential disadvantages of ETFs may be that in some niche situations, there may be less diversification in ETF investing than what someone might desire; this can be true with foreign stocks, for example—or, in some sectors, there may only be a narrow group of equities available, limiting choice.
In addition, although there are ETFs that pay dividends, they may not have as high of a yield when compared to individual stocks or stock groups with high yields. Granted, the risks are often lower when investing in ETFs—but this can translate into less reward.
This is true, at least in part, because investors can specifically select stocks because they offer the highest dividend yields; but, when putting money into ETFs, investors are choosing a bundle of investments from a broader swath of the market, which will often average out to a lower yield.
Here’s one more factor to consider about ETFs. Diversification is a commonly mentioned benefit of them, but this doesn’t mean that this type of investment won’t experience volatility, because every investment can.
How much can depend upon market conditions as well as upon the ETF’s overall focus. One that is broader will, in general, have fewer swings than those that focus on a narrow sector.
ETFs are becoming increasingly more popular, with some of them being more targeted in focus than others. So, being aware of what investments an ETF contains can be important for an investor who chooses to put dollars into this financial vehicle.
When starting out, it can sometimes help to get professional guidance to begin your investing or to pick and choose ETFs. SoFi offers its members complimentary access to financial planners who can give advice on risk tolerance and investment horizons. For those who are ready to dive into ETF investing on their own, the SoFi Active Investing platform may be a good option.
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