Investing 101: ETFs
Exchange-traded funds. ETFs. Even if you don’t know all there is to know about ETFs already you’ve almost certainly heard the term. Let’s talk about what ETFs are, why they’re so popular, and what you can do with them.
An exchange-traded fund is a fund traded on an exchange – makes sense, right? Like a mutual fund and ETF is an entity that owns underlying investments, and like a stock or option they’re traded on exchanges at whatever the market price is. When you buy a share of an ETF you’re buying a part of a company that owns all of those underlying securities. You can think of it as buying a little sliver of all of the underlying securities yourself, as an ETF’s price will usually change almost identically to the changes in those underlying securities. For this privilege you pay an expense ratio, or a percent of your investment, to the fund’s owning company and management. This is usually invisible – it’s taken out before you ever see the returns on your investment.
Because ETFs are all about what they own there are as many kinds of ETFs as there are combinations of stocks, bonds, and even derivatives. In fact, at last count, there are 6,970 ETFs registered and traded in the US, compared to 3,671 domestic stocks listed on US exchanges – that’s almost twice as many ETFs as actual stocks.
These ETFs might be focused on an index (like the S&P 500, or the MSCI EAFE international developed markets index), on a sector (like healthcare, information, or finance), a task (generating income, or finding growth in small-cap US companies), on bonds, commodities, real estate, or anything else you can think of. With all those ETFs out there it’s hard to keep track of all of them, but the good news is: you don’t have to.
ETFs only came into existence in the last thirty years, but in that time have become one of the most popular ways to invest. This boils down to a few factors: they’re low cost, they’re easy to buy and sell, and they’re extremely useful for building a portfolio.
Unlike mutual funds most ETFs are passively managed. There are exceptions, certainly, but the ETFs that are traded the most are following specific indices or other bundles of investments that don’t need frequent hands-on management. This means they’re cheap!
You’ll pay for the privilege of owning an ETF but we’re talking about a half, or quarter, or tenth of a percent (average: 0.44%) compared to the one or two percent you might pay on an actively managed mutual fund. If you’re building a portfolio, especially a long-term portfolio, keeping those internal costs low is invaluable.
Easy to Buy and Sell
Mutual funds trade at the end of the business day. Bonds may be difficult to move. ETFs trade regularly during all market hours. You can buy an ETF and sell it the same day, if you need to. For a retail investor (like me or you) there are big advantages to being able to buy or sell securities at any time of day. You can trade them through your brokerage with just a few clicks.
Which portfolio is more diversified: one that has 40 stocks, 50 bonds, and handful of commodities and cash; or one that has 8 ETFs? Your impulse might be to say that the portfolio with a hundred positions is inherently more diverse than the portfolio with only eight, but that’s probably not the case. ETFs regularly carry dozens or hundreds of positions. Any ETF built to track the S&P 500 probably has, you guessed it, about five hundred, and the same logic goes for any other index ETF. The point here is: you can build a great, diverse portfolio out of a handful of ETFs and do so with a hundredth the effort you’d spend doing it with individual securities.
So now we know what ETFs are (products that allow you to buy big bundles of underlying securities at once), and we know why people like them (they’re cheap, easy, and useful!), so what does that do for you?
Well, the obvious answer is you can use ETFs to construct a diverse asset allocation portfolio incorporating stocks, bonds, and other assets with just a few ticker symbols. The real answer is: you can use ETFs to pursue almost any investment goal you have. While most investors will be best suited by a portfolio like that described above, that may not be you. Here are a few examples of what you can use ETFs to do:
Create a socially responsible portfolio. There are now hundreds of ESG (Environmentally-, Socially-, and Governance-aware) ETFs on the market, and with some careful picking you can create a portfolio for any goal that invests in responsible stocks and bonds.
Hedge your main portfolio. Maybe you already have a large portfolio or specific position and you’re looking to create a hedge against market turbulence. Inverse ETFs that attempt to behave opposite the market’s behavior can help you introduce some stability in rough periods.
Speculate. Leveraged ETFs make use of derivatives and margin to magnify the movements of the market: when the underlying index is up the ETF will be way up, and when the underlying index is down the ETF will be way down. If you’re anticipating a sudden boom you can lean into it by picking up speculative leveraged ETFs with a (small) portion of your portfolio.
Concentrate in a Sector. Want exposure to the market as a whole, but want to overweight (or focus entirely on) a specific sector like healthcare, information, or real estate? Easy! There are ETFs for every sector, and if you buy into those in addition to or in place of your primary investments you can get the benefits of being in that sector without having to pick specific stocks.
Find Tax Efficiencies. Tax-loss harvesting is a great way to defer some of your tax responsibilities. Let’s say you’ve got $100,000 in a large-cap domestic index ETF and it drops to $80,000. Now is the time to strike! You may be able to sell out of that whole position and move the funds to a similar-but-not-identical large-cap domestic index ETF and claim that $20,000 capital loss now, but not change the fundamental composition of your portfolio. Your financial advisor may even be able to automate the process for you – ask them how they create tax-efficient portfolios and whether it’s a smart idea for you.
And that just scratches the surface of the value in ETFs. Wherever you are in your investing education, it’s worth the time to speak to a financial advisor about what role ETFs play in your portfolio, and how you can benefit from understanding these mechanics in the future.