The exchange traded funds (ETFs), as they are commonly known, have become the darlings of the investment world. So potential investors need to get educated about ETFs, so they can make smart decisions about whether they should invest in them. We'll start with a definition, but before you can understand what an ETF is, you need to know what an equity index is.
What is equity index?
An equity index is a group of stocks, often referred to as a basket, that represents an industry. For example, the Oil Index (OSX) is a collection of shares from different oil companies. If you want to buy shares in OSX, you will need to buy shares of about 15 different stocks. That can be pretty difficult and expensive, considering stock prices tend to move often, and commissions on all of those buys can be pricey.
An exchange traded fund is an investment whose performance is based on a related index. Sticking with the oil example, OIH is an oil ETF that follows the OSX index, so if the OSX is up, the OIH probably is too. An exchange traded fund is meant to mimic, not outperform its correlating index. The best thing about an ETF is you don't have to buy that basket of stocks. You pay one price for one investment, like an equity.
Pros And Cons of ETFS
Before you can make an informed decision about whether to invest in an ETF, you should understand the pros and cons so you will be in a better position to use the correct investment strategy when exchanged traded funds are part of your portfolio.
- You can buy an ETF in one transaction, making it easier to target a certain price.
- Because you're not buying a basket of stocks, commissions are lower, and ETFs have no load fees and smaller management fees than mutual funds.
- Capital gains taxes usually are lower for exchange traded funds than for traditional mutual funds.
- Many ETFs list futures contracts, which help risk-managing your portfolio.
- ETF companies publish a list of the assets in the fund on a daily basis.
- Because exchange traded funds are meant to follow a particular index, not outperform it, usually only minor adjustments are needed to the ETF, unlike an aggressively managed fund which is looking for a higher return than its underlying asset. This lowers risk.
- Most ETF companies immediately reinvest dividends back into the fund.
- ETFs are less common in other countries, so if you want your investment portfolio to have international exposure, this isn’t a great way to go.
- Exchange traded funds sometimes have low trading volumes, and when they do, the advantage of buying them diminishes.
- The intraday trading opportunities created by ETFs are good for short-term traders but may not fit into a long-term investor’s strategy.
So now that you have a basic understanding of exchange traded funds, here are a few tips that may help you determine how and what to buy:
- 1. Learn About The Different Types Of ETFs. When it comes to exchange traded funds, the sky is the limit, and it can be overwhelming to try to figure out what to buy. Start with understanding the major types of ETFs: U.S. market index, foreign market index, foreign currency, bond, style, derivative, commodity, sector, industry, inverse and exchange traded notes. Understanding more about these types will help you figure out which will fit your investing strategy.
- 2. Decide On The Best Strategy. Speaking of strategy, you need to figure out what yours is. Do you want to expose your portfolio to a particular market, such as gold or oil? Do you want to use ETFs as a hedge against foreign risk? Whatever the reason, determine why you are investing in these funds so you can formulate a strategy.
- 3. Understand How Exchange Traded Funds Will Affect Your Tax Return. A lot of investors like ETFs because of the tax advantages they offer compared with mutual funds. Because of the way ETFs are structured, capital gains taxes are not realized the same way as other investment products.
If you complete your research and decide to invest in an exchange traded fund, just call your financial adviser to create an account or open an online brokerage account. Even if you decide to do the latter, many financial advisers will meet with you for free or at a reduced rate to give you advice. It is probably worth the money to be sure this investment is for you.