Over the past decade, the exchange-traded fund (ETF) has made its way into an increasing number of investors’ portfolios, and it’s not hard to see why. An ETF is a basket of securities that trades on an exchange, much like stocks do. However, unlike individual stocks, ETFs track broad market indexes such as the S&P 500 and the Dow Jones Industrial Average. They can also track smaller, more narrowly focused indexes. The price of an ETF corresponds to the performance of its underlying holdings, moving higher and lower throughout the day until the close of market. To understand the emergence of ETFs, and why this development may be important to the individual investor, it’s helpful to look at their distinctive characteristics.
ETFs can offer a relatively inexpensive way to build a broad and diverse investment portfolio. An investment cost analysis done by Bloomberg points out that the average annual expense of an ETF is about 0.5%. That cost can be even lower if you own some of the more popular ETFs, which trade heavy volume each day. That contrasts with actively managed equity mutual funds, which average 0.89%, according to the analysis, with some considerably higher than that.
Another defining trait of ETFs is their liquidity. They can be purchased and sold during market hours, similar to stocks. Many ETF investors may choose not to trade that way, as these securities are often purchased as long-term holdings, but that ability to buy and sell an investment intraday may be reassuring to some investors, as it provides additional access and control. The mutual fund vehicle, whether index or actively managed, allows investors to buy in or sell out only once per day, at market close.
Transparency is another key trait of ETFs. Whereas some investment products make it difficult to know exactly what they own on any given day, most ETF sponsors allow you to view fund holdings each day as of the prior day’s market close. This allows investors to know exactly what they own as opposed to having only an approximate idea.
Finally, we have tax efficiency. Unlike mutual funds, which regularly buy and sell securities to accommodate new purchase orders and redemptions, ETFs utilize an efficient process of exchanging creation units, which comprise the ETF’s underlying holdings. This helps the ETF to avoid the taxes generated by processing investment sales because, in nearly all cases, they are swapping a basket of the underlying security for shares in the ETF. Naturally, an investor will still incur taxes if they generate a capital gain when they eventually sell their ETF shares. Similarly, they will still owe tax on the dividends or income generated by ETFs held in taxable accounts.
ETFs can be used for exposure to equities in the investor’s choice of market capitalizations, including large-cap, mid-cap, and small-cap. Additionally, investors can find ETFs that track indexes in Europe, the Far East, and emerging markets, as well as in the healthcare, technology, and other sectors. ETFs even provide easy access to different sectors of the bond market.
The market for ETFs continues to mature, and investors can find ETFs that track everything from the broadest market indexes to narrowly focused funds. More than ever, it’s possible to construct a portfolio with an array of ETFs that help meet very specific needs. And because they meet each of those needs using a wide selection of securities, rather than just a few, they provide an easy way to achieve true diversification.