ETFs Can Offer Reduced Risk, Less Volatility

By Dan Greenshields, CFA

The last two years in the global financial markets can make any investor wince; the huge swings have left many investors shaking.

As we know, too many new and experienced investors put all their chips into one or two different stocks, crossed their fingers, and hoped for the best. This, combined with one of the worst market downturns in decades, decimated a significant percentage of the retirement savings and investment accounts of everyday Americans.

The recent market roller coaster has bolstered the case for finding investments that are lower-cost and diverse. Enter Exchange Traded Funds (ETFs). Even if you do not have a portfolio as big as Warren Buffett's, you can have a similar strategy by placing added emphasis on ETFs in your portfolio. Those who have a diversified ETF investment strategy may benefit from reduced risk and volatility.

What is an ETF?

ETFs are essentially a basket of stocks lumped into one investment that trades on exchanges around the world. The sub-segment of the industry began in 1993 with State Street (STT Quote) issuing the Spider, an Index fund linked to the S&P 500. There are now over 300 indexed ETF funds in the U.S. focused to everything from Gold, Real Estate and Treasury Bonds to Bio-Tech. Most ETFs have the same diversification benefits as mutual funds, but with lower management costs driven by their indexing approach.

How Do ETFs Work?

An ETF is a security registered with the SEC for trading on U.S. exchanges like the NYSE. ETF prospectuses describe in detail what and how the investment strategy will be executed. However, ETFs have several key features which distinguish them from their mutual fund and closed end fund cousins. Indexed ETFs are not actively managed. The manager is just balancing the portfolio and participating in the underlying index, commodity or industry where the ETF is invested. ETFs trade on an exchange and the price fluctuates throughout the trading day, unlike mutual funds whose value is based on one calculated price ("NAV" = net asset value) at the end of the day.